Earned income is taxable, and the rate is chosen based on the individual’s or couple’s income bracket. The lower the income that the individual or couple earns, the less tax they need to pay. On the other hand, the higher the income earned, the more taxes the individual or couple would need to pay.
For example, if an individual earns approximately $20,000, they need to pay approximately 10%-15% of tax. On the other hand, a married couple earning over $620,000 would be subject to a 37% tax rate. Ultimately, the thresholds vary based on single and married couples.
How Earned Income is Calculated
According to the Government of Canada, earned income is calculated by adding employment earnings, self-employment earnings, and other specific types of income. The sum is then subtracted by specific employment expenses and business or rental losses.
Additional Considerations for Earned Income
If one receives social security benefits, they may need to pay a certain percentage of that fee if they are earning income above a certain threshold. Particularly, 50%-85% of the benefits can be subject to tax – it is entirely dependent on the amount of earned income being generated.
If an individual is an entrepreneur, they must consider the amount of income they earn themselves through the year, as they must pay taxes each quarter based on that estimate. In the scenario where they do not pay enough taxes, they would face IRS penalties.
If an individual’s income is low, they may be eligible for the federal earned income tax credit, which ultimately reduces the tax bill or provides a refund.
Understanding the Earned Income Tax Credit
The earned income credit helps low-income taxpayers by reducing the amount of taxes they must pay every year. It was introduced as an opportunity to lower poverty and encourage individuals to work. It is only available to low-income earners, as well as low/mid-income families.
In such cases where they are eligible for the earned income tax credit, households can bring their tax liability to zero, which allows them to pay zero taxes. In a scenario where the income taxes that are owed goes below zero, the government would then issue the individuals or families a tax refund of the difference between the negative value and 0.
How Tax Credits Work
A tax credit is capable of lowering the taxpayer’s liability. For example, an individual who needs to pay a tax bill of $3,500 but can also claim $600 would reduce their taxes by $600, which means they would need to pay $3,500 – $600 = $2,900.
Gross Income vs. Earned Income
The primary differences between gross income and earned income are the following:
Gross income aggregates what the individual earned throughout the year as both a worker and an investor. The Internal Revenue Service (IRS) defines it as all the income an individual would receive in the form of cash, goods, real estate, and services that are all taxable.
Gross income also includes investment income that comes from interest and dividends, along with retirement income. On the other hand, earned income includes only what is earned on the job, such as wages, commissions, and bonuses.
The IRS also states that earned income includes certain taxable benefits, such as long-term disability benefits and strike benefits that arise from union activities. Thus, the primary difference is that earned income does not include passive income. As a whole, gross income is used for tax preparation and filing, which helps determine tax liability.
An aggregate of all an individual's earnings (Cash, goods, real estate, and services)
Includes only what is earned on the job
Includes investment income from interest and dividends, and retirement income
Includes wages, commissions, and bonuses
Used for tax preparation and filing
Includes certain taxable benefits (long-term disability benefits and strike benefits)
CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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