Earned income

Definition

Earned income refers to the money earned by an individual through work or services performed, including wages, salaries, tips, and self-employment income. It is one of the key components of gross income and is crucial in determining tax liability. Understanding earned income is essential for grasping how it fits into the broader picture of gross income, especially when looking at taxable income and potential deductions.

5 Must Know Facts For Your Next Test

1. Earned income is subject to federal income tax and often also to payroll taxes like Social Security and Medicare.
2. Certain forms of income, like interest or dividends, are classified as unearned income and do not count as earned income.
3. For tax purposes, earned income can impact eligibility for various credits and deductions, such as the Earned Income Tax Credit (EITC).
4. Self-employed individuals report their earned income on Schedule C of their tax return, while employees report theirs via a W-2 form.
5. The IRS defines earned income specifically to differentiate it from passive forms of income, impacting how much tax an individual must pay.

Review Questions

• How does earned income differ from unearned income in terms of tax implications?
  • Earned income is generated through active work or services performed, making it subject to different tax rules compared to unearned income, which includes interest or dividends. While both types contribute to gross income, earned income typically incurs payroll taxes such as Social Security and Medicare. In addition, earned income can qualify taxpayers for certain credits like the Earned Income Tax Credit (EITC), while unearned income does not.
• Discuss the significance of reporting earned income accurately on tax returns.
  • Accurate reporting of earned income on tax returns is crucial because it directly affects tax liability and eligibility for credits and deductions. Misreporting can lead to underpayment or overpayment of taxes, resulting in penalties or missed opportunities for refunds. Furthermore, since forms like W-2s and Schedule Cs are used to report this income, discrepancies can trigger audits or additional scrutiny from the IRS.
• Evaluate the role of earned income in determining overall financial health and access to benefits like loans or insurance.
  • Earned income plays a significant role in assessing overall financial health since it reflects an individual's ability to generate revenue through work. Lenders often evaluate earned income when determining loan eligibility, as it indicates stability and capacity to repay. Similarly, insurance providers may consider earned income when calculating premiums or coverage options, linking financial viability to access to essential services and resources.

Related terms

Gross Income: The total income received by an individual before any deductions or taxes, which includes both earned and unearned income.

Self-Employment Income:

Income earned by individuals who work for themselves rather than as an employee, which is considered earned income for tax purposes.

W-2 Form: A tax form that employers must provide to their employees, summarizing wages and taxes withheld, essential for reporting earned income.