What is Earned Income?
The term earned income is relevant for taxation purposes. It includes means any income derived from working for an organization or for someone or participating in any trade or business activity. The income can be either derived from rendering service to others or from your own business. Whether income is earned is important for taxation purposes. Former of unarmed income may include: interest, dividends, social security, retirement benefits, unemployment benefits, alimony, and child support.
How Does Earned Income Work?
Earned income is subject to a higher level of taxation than unearned income. Earned income is subject to payroll taxes (or self-employment taxes if you have your own business). As such, the employer is required to deduct state, municipal, federal taxes. Most notably, the company will deduct Federal Insurance Contribution Act (FICA) taxes. FICA Taxes – FICA consisted of social security and Medicare taxes. Currently, social security taxes is 12.4% of earned income up to $126,000 of earned income. Medicate is 2.9% of earned income (with no applicable cap). Employers pay one-half of FICA taxes and the employee pays the other half. Self-employed individuals pay the entire tax amount. Further, because there is no employer to withhold FICA taxes, the self-employed individual will need to calculate her taxable income and pay applicable income and FICA taxes to the IRS either monthly, quarterly, or annually.
- Note: It is worth noting that the Internal Revenue Code (IRC) provides a tax credit for individuals and couples with dependent children who have low levels of earned income.
Lastly, earned income is generally treated as active income, where unearned incomes is treated as passive income. The designation as active and passive is important for determine whether profits and losses can offset each other. Passive losses can generally only offset passive losses. Likewise, active losses can only offset active profits. Of course, there are numerous special provisions under the IRC that affects this limitation.