When you own or work for a business, you receive earned income. But, not all income is earned income. Both business owners and employees should understand what is earned income to determine tax liability and tax credit eligibility.
So, what is it?
Earned income definition
Earned income is the total taxable compensation (e.g., wages or salaries) an employee earns, or the net earnings a self-employed individual earns, for work. Both employees and self-employed individuals receive earned income and pay taxes on that income.
Regular wages aren’t the only type of compensation that contributes to earned income. Here’s a list of income the IRS considers earned:
- Wages, salaries, tips, commissions, and bonuses
- Self-employed earnings after deducting business expenses (i.e., net income)
- Statutory employee net earnings
- Union strike benefits
- Disability retirement benefits received before minimum retirement age
- Nontaxable combat pay, if elected
What types of income are NOT earned?
Again, not all types of income are earned. The IRS classifies some forms of income as unearned income.
Here are a few examples of unearned income:
- Interest earned
- Social Security benefits
- Unemployment benefits
- Workers’ compensation benefits
- Welfare benefits
- Child support
- Payment for work done while incarcerated
- Disability benefits received after reaching retirement age
- Disbursements from non-deferred retirement plans
- Pensions or annuities
When you receive unearned income, you do not owe payroll taxes on the amount. However, you still owe taxes on unearned income.
Why does it matter?
Earned income determines tax liabilities, whether someone can make IRA contributions, and eligibility for the earned income tax credit.
Earned income is subject to employment taxes. In an employee’s case, employment taxes include income, Social Security, and Medicare taxes. In a self-employed individual’s case, earned income is subject to income tax and self-employment tax.
To determine your tax liability or your employee’s tax liability, you need to know the amount of earned income that is subject to taxation.
If you or an employee wants to contribute to an Individual Retirement Account (IRA), you must receive earned income. Individuals who do not receive earned income cannot contribute to an IRA.
Your annual earned income may also be the baseline for how much you can contribute to your IRA. If you earn below the IRA contribution limit, you cannot contribute more to your IRA than your earned income amount.
Earned income tax credit
Another reason earned income is important is that it affects eligibility for the earned income [tax] credit (EITC or EIC).
The earned income tax credit is an IRS program that helps alleviate tax liability for low- and moderate-income individuals with earned income.
The EITC is a refundable tax credit, which means that individuals with a higher tax credit than tax liability receive a refund.
So, how much is the tax credit? The credit amount, as well as your eligibility for earning it, depends on how much you receive per year.
You cannot receive the tax credit if your earned income is above the IRS threshold. So, are you eligible for the credit?
Here are the annual maximum amounts you can have in earned income to receive the EITC, based on children:
- 0 children: $15,820 (single) or $21,710 (joint)
- 1 child: $41,756 (single) or $47,646 (joint)
- 2 children: $47,440 (single) or $53,330 (joint)
- 3 or more children: $50,954 (single) or $56,844 (joint)
If your annual earned income is less than these thresholds, you may be eligible for the credit. However, you cannot claim the credit if you are married and file separately.
Again, the EIC doesn’t just pertain to you. Your employees may also be eligible for the credit.
As an employer, you are responsible for letting employees know about the EITC if you do not withhold federal income tax from their earned income. Let the employee know by providing Notice 797. Keep in mind that you do not have to provide Notice 797 if the employee claimed exemption from income tax withholding.
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This article has been updated from its original publication date of September 3, 2015.This is not intended as legal advice; for more information, please click here.