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What Is Earned Income? Examples and How to Calculate

Byline profile imageEdited by Mo Mozuch
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Byline profile imageEdited by Arturo Conde, CEPF®
Byline profile imageReviewed by Michele Cagan, CPA
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When it comes to taxes and financial planning, you need to know the IRS has different rules for different types of income. Earned income, the money you make from working, affects everything from how much taxes you pay to whether you qualify for certain deductions or credits. Whether you’re earning a paycheck from an employer, running your own business or freelancing on the side, knowing how to identify and calculate your earned income can help you stay compliant with IRS rules and potentially lower your tax bill. 

Managing taxes can be challenging, but an experienced financial advisor can help simplify the process. 

What Is Earned Income?  

Earned income refers to compensation from active work, such as wages, salaries, tips or self-employment earnings. This differs from unearned income, which comes from sources like investments, interest or rental properties. 

Generally, the IRS considers earned income what you receive for performing work or services. For the employed, earned income typically includes your wages or salary. For the self-employed, income typically encompasses business profits. 

Here are some common examples of earned income:

  • Salaries and wages: This includes hourly pay, annual salaries, overtime and bonuses.
  • Self-employment earnings: Income from businesses, freelancing, or contract work like consulting fees. However, you may not have this income come through you directly, depending on how you register your business.

Here are some examples of what is not considered earned income:

  • Interest and dividends: This passive income comes from investments, such as stock or bonds.
  • Capital gains. The IRS considers profits from selling investments or property as unearned income.
  • Retirement distributions: Pension payments, Social Security benefits, and withdrawals from individual retirement accounts(IRAs) or 401(k)s.
  • Unemployment compensation: While it replaces earned income, IRS rules do not consider it earned income.
  • Alimony and child support: Though these payments provide financial support, they are not classified as earned income.

How Earned Income Is Calculated

You can calculate earned income by adding up all compensation you receive for active work.

Calculating earned income starts with identifying any compensation you receive in exchange for active work like wages, salaries, tips and commissions. For self-employed or business owners, you calculate earned income by subtracting business expenses from your gross revenue to get your net profit.

For Employees:

If you work for an employer, earned income typically includes:

  • Hourly wages or salary
  • Overtime pay
  • Bonuses and commissions
  • Tips and gratuities

For Self-Employed Individuals:

Freelancers, contractors, or business owners calculate earned income using the following:

  • Gross income from your business
  • Minus allowable business expenses

For example, say you operate a consulting business that brings in $120,000 in gross revenue. After deducting $35,000 in expenses, such as office supplies, marketing costs and travel, you’re left with $85,000 in net earnings, which is your earned income for tax purposes.

Earned Income vs. Unearned Income 

The distinction between earned and unearned income can help you better manage your finances and plan your taxes. Here are four key differences to consider:

  • Income source: Simply put, earned income comes from active work. For example, self-employment income if you’re running your own consulting business. Unearned income, on the other hand, comes from passive sources, such as dividends and interest from investments, gains from the sale of investment assets, retirement distributions, unemployment benefits and various government support payments.
  • Tax treatment: The IRS taxes earned income at ordinary income rates and is subject to payroll taxes for Social Security (up to the annual cap) and Medicare. Unearned income receives different tax treatment. The IRS taxes capital gains and qualified dividends at preferred rates, but taxes ordinary dividends and interest income at ordinary rates. Some unearned income sources may require an additional 3.8% net investment income tax (NIIT).
  • Limits and exclusions: Not all income can be classified as earned or unearned. For example, incentive stock options (ISOs) do not create income impacts until exercised or sold.
  • Tax benefit eligibility: Some tax credits and deductions, like the earned income tax credit (EITC), are available only for taxpayers with earned income. 

Want to see the potential effect of tax credits? Get an estimate with our calculator.

Income Tax Calculator

Calculate your federal, state and local taxes for the 2025 tax year.

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About This Calculator

Our income tax calculator calculates your federal, state and local taxes based on several key inputs: your household income, location, filing status and number of personal exemptions.

How Income Taxes Are Calculated

  • First, we calculate your adjusted gross income (AGI) by taking your total household income and reducing it by certain items such as contributions to your 401(k).
  • Next, from AGI we subtract exemptions and deductions (either itemized or standard) to get your taxable income. Exemptions can be claimed for each taxpayer.
  • Based on your filing status, your taxable income is then applied to the tax brackets to calculate your federal income taxes owed for the year.
  • Your location will determine whether you owe local and / or state taxes.

When Do We Update? - We check for any updates to the latest tax rates and regulations annually.

Customer Service - If you would like to leave any feedback, feel free to email info@smartasset.com.

Assumptions

Deductions

  • "Other Pre-Tax Deductions" are not used to calculate state taxable income.

Credits

  • The only federal credit automatically calculated is the Savers Credit, depending on your eligibility.
  • We do not apply any refundable credits, like the Child Tax Credit or Earned Income Tax Credit (EITC).
  • We do not apply state credits in our calculations.

Itemized Deductions

  • If itemizing at the federal level, you may need to itemize at the state level too. Some states don't allow itemized deductions, which is accounted for in our calculations.
  • When calculating the SALT deduction for itemized deductions, we use state and local taxes, and we assume your MAGI.
  • We assume that there is no cap to itemized deductions, if a state allows them.
  • We do not categorize itemized deductions (such as medical expenses or mortgage interest), which could be subject to specific caps per state.

Local Tax

  • Depending on the state, we calculate local taxes at the city level or county level. We do not include local taxes on school districts, metro areas or combine county and city taxes.
  • With the exception of NYC, Yonkers, and Portland/Multnomah County, we assume local taxes are a flat tax on either state taxable income or gross income.

Actual results may vary based on individual circumstances and changes in tax laws or IRS regulations. Estimates provided by this calculator do not guarantee income tax amounts or rates. Past performance is not indicative of future results.

SmartAsset.com does not provide legal, tax, accounting or financial advice (except for referring users to third-party advisers registered or chartered as fiduciaries ("Adviser(s)") with a regulatory body in the United States). Articles, opinions and tools are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual. Users should consult their accountant, tax advisor or legal professional to address their particular situation.

Frequently Asked Questions 

Can Passive Income Be Considered Earned Income? 

Passive income, by definition, is typically not classified as earned income. However, the IRS may occasionally reclassify some types of passive income under specific circumstances.

How Is the Earned Income Tax Credit Determined? 

The EITC is calculated based on your earned income, adjusted gross income and the number of qualifying children you have. Using an EITC calculator can provide a more personalized estimate.

Bottom Line

A financial advisor meeting with a client to discuss different tax credits.

Whether you’re earning a steady paycheck, running your own business or taking on freelance work, knowing how your income is classified is key to staying compliant with tax rules and unlocking potential tax benefits. If you’re unsure how to categorize your earnings or want to optimize your financial strategy, working with a financial advisor can help you stay on track and make the most of your income.

Tax Planning Tips

  • If you’re looking for ways to lower your tax liability, a financial advisor can help optimize your finances. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If you want to know how much your next tax refund or balance could be, SmartAsset’s tax return calculator can help you get an estimate.

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