Key takeaways
– Earned income is money you receive for working: wages, salaries, tips, bonuses, commissions, and net earnings from self‑employment. (Investopedia; IRS)
– Unearned income is money from non‑work sources: investment income, most government benefits, pensions, capital gains, dividends, etc. Tax rules differ for earned vs. unearned income. (Investopedia; IRS Pub. 525)
– Earned income is required to claim contributions to most IRAs and to qualify for the Earned Income Tax Credit (EITC). Qualification rules and dollar limits change annually; check the IRS for current thresholds. (IRS Pub. 596; IRS EITC page)
Understanding earned income
– What it is: Compensation you receive because you worked. Typical items:
– Wages and salaries reported on Form W‑2
– Tips (reported and unreported when required by law)
– Bonuses and commissions
– Net profit from self‑employment (reported on Schedule C / Schedule SE)
– Some special items for tax purposes (e.g., certain long‑term disability payments, union strike benefits, some deferred compensation in specific cases)
– What it isn’t (examples of unearned income): interest, dividends, capital gains, most Social Security benefits, unemployment, workers’ compensation, most welfare payments, most pension distributions, rental passive income, inheritances, and gifts. (Investopedia; IRS Pub. 525)
Why the distinction matters
– Different tax treatment: earned income is subject to payroll taxes (Social Security and Medicare) and ordinary income tax brackets; many types of unearned income face different tax rules (e.g., capital gains rates). (IRS)
– Eligibility for tax benefits: EITC and the ability to contribute to an IRA (except spousal IRAs) require earned income. (IRS Pub. 596; IRS Pub. 590‑A)
– Estimated tax/withholding: Self‑employed people must pay self‑employment tax and usually make quarterly estimated tax payments. (IRS)
Types of earned income (common)
– Employee compensation: wages, salary, bonuses, tips, commissions (W‑2)
– Self‑employment income: net profit from a business or gig work (Schedule C)
– Farming income (Schedule F)
– Some disability and strike benefits (subject to rules)
– Certain payments from deferred compensation arrangements in specific situations (check plan rules and IRS guidance)
Tax considerations — brief practical overview
– Reporting:
– W‑2 wages go on Form 1040 (wages line).
– Self‑employment net income goes on Schedule C and self‑employment tax on Schedule SE.
– Unearned items have their own lines/schedules (Schedule B for interest/dividends, Schedule D for capital gains, etc.). (IRS forms pages)
– Payroll taxes: Employees split FICA taxes (employer/employee share); self‑employed persons pay both shares via SE tax.
– IRA contributions: Generally you must have earned income to contribute to a traditional or Roth IRA (exceptions for spousal IRAs). (IRS Pub. 590‑A)
– Social Security benefits: Up to 50% or 85% of benefits may be taxable depending on combined income and filing status. (IRS Pub. 915)
– Tax brackets and special rates change annually. Long‑term capital gains use lower preferential rates (0%, 15%, 20% depending on income and filing status). Short‑term gains taxed as ordinary income. (IRS)
Earned Income Tax Credit (EITC) — overview
– Purpose: A refundable tax credit designed as a work incentive and anti‑poverty measure for low‑ to moderate‑income workers and families. (IRS Pub. 596)
– Benefit: Can reduce tax liability and produce a refund even when no income tax is owed.
– Amount and thresholds: Depend on filing status, number of qualifying children, and earned income; limits are updated annually.
Qualifications for the EITC (key tests)
– You must have earned income during the tax year.
– Your earned income and adjusted gross income (AGI) must be below the annual threshold for your filing status and family size.
– You (and your qualifying children, if claiming them) must meet residency, relationship, and age rules; you must have valid Social Security numbers.
– You cannot file Married Filing Separately to claim the EITC.
– Investment income must be below the annual cap for EITC. (See IRS Pub. 596 and IRS EITC page for full rules)
Practical steps to determine and calculate earned income
1. Gather documents
– W‑2s for wages, 1099‑NEC/1099‑MISC for contractor payments, 1099‑INT/1099‑DIV for unearned income, brokerage statements for capital gains.
– Records of tips, side‑gig income, and business expenses (receipts, logs).
2. Classify each income item as earned or unearned
– If you were paid for performing work → normally earned.
– If the money came from ownership, investments, gifts, inheritances, or most government benefits → normally unearned. (Refer to IRS Pub. 525)
3. Compute earned income totals
– Employees: use gross wages (box 1 on W‑2 for federal wages) plus taxable tips and other compensation.
– Self‑employed: compute gross receipts minus allowable business expenses = net earnings (Schedule C).
– Add together wages + net self‑employment income + taxable tips + taxable bonuses/commissions.
4. Apply special rules if needed
– For EITC, use earned income as computed per IRS rules; certain items (e.g., nontaxable combat pay) have special election rules.
– For IRA contribution eligibility, use earned income amount (see IRS Pub. 590‑A).
5. Report on your tax return
– Enter wages on Form 1040 line for wages; attach Schedule C for self‑employment income and Schedule SE for self‑employment tax. Follow Form 1040 instructions and schedule line items for unearned income. (IRS Form instructions)
Example (simple)
– W‑2 salary: $50,000
– Bonus: $10,000
– Side‑gig wages: $5,000 (reported on 1099 or cash)
– Tips: $500
– Ordinary dividends: $1,000 (unearned)
– Capital gain distributions: $25,000 (unearned)
– Earned income = 50,000 + 10,000 + 5,000 + 500 = $65,500
– Unearned = 1,000 + 25,000 = $26,000 (reported separately). (Illustrative example based on common practice; see IRS guidance)
Common examples of unearned income
– Interest and dividends
– Capital gains and distributions
– Pensions and most retirement plan distributions
– Social Security benefits (may be partly taxable)
– Unemployment compensation, workers’ compensation (generally unearned)
– Rental passive income (unless materially participating)
– Inheritances and gifts
How do I know if I have earned income? (Practical checklist)
– Were you paid to perform work? Yes → likely earned.
– Is the payment reported on a W‑2 or as self‑employment income on a 1099/records? Yes → earned.
– Is the payment from investments, a government benefit, or a pension? Likely unearned.
– Unsure? Review IRS Publication 525 (“Taxable and Nontaxable Income”) and Pub. 596 for EITC specifics, or consult a tax professional.
Differences between earned and unearned income — quick comparison
– Source: Work vs. investments/benefits
– Payroll taxes: Earned income → subject to payroll/Self‑Employment tax; unearned generally not subject to payroll tax
– Use for tax credits/retirement contributions: Earned income required for EITC and IRA contributions; unearned income usually disqualifies those uses
– Tax rates: Earned income taxed at ordinary rates; some unearned (e.g., long‑term capital gains, qualified dividends) may get preferential rates
Practical steps for taxpayers (to minimize surprises and maximize benefits)
– Keep good records of all earnings and business expenses (including tip logs, mileage, invoices).
– Use W‑2s, 1099s, and business records to classify income correctly.
– If self‑employed, estimate quarterly taxes and make payments to avoid penalties.
– Check EITC eligibility each year — even if you owe no tax, you must file to claim it.
– Use IRS online tools: the EITC Assistant and withholding estimator, and review Publication 596 and applicable forms.
– If you receive disability or other unusual payments, review plan terms and IRS guidance to determine taxability and whether they count as earned income.
– When in doubt, consult a tax professional or the IRS for your specific situation.
Important reminders
– Tax rules and dollar thresholds change annually. Always verify current year limits (EITC income caps, IRA contribution rules, investment income limits for EITC, etc.) on the IRS website.
– Misreporting earned vs. unearned income can affect eligibility for credits like the EITC and can trigger IRS notices or audits.
Where to learn more (primary sources)
– Investopedia — Earned Income: https://www.investopedia.com/terms/e/earnedincome.asp
– IRS — Publication 596, Earned Income Credit (EIC): https://www.irs.gov/pub/irs-pdf/p596.pdf
– IRS — Earned Income Tax Credit (EITC) overview: https://www.irs.gov/credits-deductions/individuals/earned-income-tax-credit-eitc
– IRS — Publication 525, Taxable and Nontaxable Income: https://www.irs.gov/pub/irs-pdf/p525.pdf
– IRS — Publication 590‑A, Contributions to Individual Retirement Arrangements (IRAs): https://www.irs.gov/pub/irs-pdf/p590a.pdf
– IRS — Publication 915, Social Security and Equivalent Railroad Retirement Benefits: https://www.irs.gov/pub/irs-pdf/p915.pdf
– IRS — About Form 1040 and schedules: https://www.irs.gov/forms-pubs/about-form-1040
If you’d like, I can:
– Walk through a personalized calculation with your specific income items.
– Check EITC eligibility for a given filing status and number of children (using current‑year thresholds).
– Explain how to report self‑employment income and estimate quarterly payments.