How Does Earned Income Affect My Taxes?
For Employees and Self-employed
Individuals and businesses have two types of income. One type is active income; that is, income from active work as an employee or self-employed individual.
The other type is passive income that comes from collecting money for not doing much. Investment income is passive because you basically just collect dividends. Passive income also includes income from rentals and from internet marketing ideas.
This article focuses on active, earned income and the tax implications of receiving earned income. You may have income from other passive sources, so earned income is not equal your adjusted gross income or your gross income for income tax calculation purposes.
What Is Earned Income?
Earned income is taxable income and wages you get from working. It includes:
- Wages, salary, or tips you earn from working for someone else, or as an employee of your corporation
- Income from your work in a business you own
Earned income does not include
- Interest and dividends
- Pension and retirement benefits
- Social Security
- Unemployment benefits
- Alimony or child support
How Earned Income Affects Your Tax Return
Both types of earned income (as an employee and as a small business owner) are taxable. In addition, all passive income you receive is also taxable, just on a different part of your tax return.
Earned Income as an Employee
Earned income as an employee includes not only wages, salaries, and tips, but also:
- Commissions and bonuses
- Most employee benefits
- Long-term disability benefits paid to you before your minimum retirement age, and
- Strike benefits.
- Income as a statutory employee (taxed as self-employed)
If you are an employee of another business, or you work as an employee in your corporation, you are taxed on your gross earned income for the year. As you prepare your income tax return for the year, you are separating out earned income on Line 7 of your tax return.
Earned Income as a Self-employed Business Owner
If you work for yourself, and by yourself, in a small business, you must file a business tax return, usually on Schedule C. The net income you report from this business (gross income minus deductible business expenses) is considered your earned income from the business that year.
The income you take in as net income is considered to be earned income, for two purposes:
- Income Taxes: Your net income from your business is included on your tax return in addition to earned income from other sources, to determine your total income tax bill.
- Self-employment Taxes: If your business has a positive net income for a year (that is, it's profitable), that net income is used to calculate self-employment taxes (Social Security and Medicare taxes). This tax is added to your income tax on your personal tax return.
- S corporation shareholder: The IRS says, "If you were a more-than-2% shareholder in the S corporation under which the insurance plan is established, earned income is your Medicare wages (box 5 of Form W-2) from that corporation."
The Earned Income Tax Credit
The earned income tax credit (EITC) is a refundable tax credit available to lower-income individuals and families. The credit is based on total earned income for a year, hence the name. Some states and local governments also have earned income tax credits available.
William Perez, Expert on Tax Planning, has more information about how to qualify and apply for earned income tax credits.
Foreign Earned Income Tax Exclusion
If you live and work outside the U.S., some or all of your income may be eligible to be excluded from your earned income.