Earned income

Definition

Earned income is the money that individuals receive as a direct result of their work or services, including wages, salaries, bonuses, and tips. This type of income is subject to taxation and plays a crucial role in determining an individual's tax obligations. Understanding earned income helps individuals manage their finances, plan for taxes, and maximize potential deductions.

5 Must Know Facts For Your Next Test

1. Earned income includes various forms of compensation such as salaries, wages, bonuses, commissions, and self-employment income.
2. Unlike unearned income, which includes investment income and rental income, earned income is directly related to active work efforts.
3. Earned income can qualify individuals for tax credits like the Earned Income Tax Credit (EITC), which can significantly reduce tax liability.
4. The amount of earned income impacts eligibility for certain financial aid programs and loan applications, as it reflects financial stability.
5. Self-employed individuals must report their earned income on Schedule C of their tax return and pay self-employment tax in addition to regular income tax.

Review Questions

• How does earned income affect an individual's eligibility for tax credits?
  • Earned income directly influences eligibility for several tax credits, most notably the Earned Income Tax Credit (EITC). The EITC is designed to benefit low to moderate-income working individuals and families, and its value increases with the amount of earned income up to a certain limit. This means that the more earned income a person has, the greater their potential to qualify for these credits, which can ultimately reduce their overall tax burden.
• Discuss the differences between earned income and unearned income and their implications for taxation.
  • Earned income arises from active participation in work or services, while unearned income comes from investments, interest, or rental properties. For taxation purposes, earned income is taxed at ordinary income rates and may be subject to payroll taxes, whereas unearned income might be taxed differently depending on the source. Understanding these differences is crucial as it affects how individuals plan their finances and optimize their tax situations.
• Evaluate how the concept of earned income plays a role in shaping financial planning strategies for individuals.
  • Earned income is a key component in financial planning as it provides the primary source of cash flow for most individuals. By understanding their earned income levels, individuals can better budget for expenses, save for retirement, and make informed decisions about investments. Additionally, strategies such as maximizing deductions related to earned income can lead to significant tax savings, making it essential for effective financial planning to consider not only the amount but also the sources of earned income.

Related terms

Gross Income: The total income earned before any deductions or taxes are applied.

Adjusted Gross Income (AGI): The gross income minus specific deductions, which is used to determine tax liability.

Tax Bracket: The range of income that is taxed at a particular rate, which helps determine how much tax an individual owes based on their earned income.