Understanding Taxes on Earned and Unearned Income Tax Credit
Earned income encompasses monetary compensation earned through labor, including wages, salaries, bonuses, commissions, tips, and profits from self-employment. It may also encompass long-term disability benefits, union strike compensation, and, in specific instances, payments from select deferred retirement compensation plans.
Earned Income Tax Credit
Unarned Income Tax Credit
Earned Income and the Earned Income Tax Credit
What Is Earned Income?
Earned income refers to funds received in exchange for work, including wages, salaries, bonuses, commissions, tips, and the profits generated from self-employment. It may also encompass long-term disability benefits, compensation during union strikes, and, on occasion, disbursements from specific deferred retirement compensation plans.
Earned income stands in contrast to unearned income, often referred to as passive income, which is money acquired without active labor or work.
Comprehending Earned Income
For tax purposes, earned income refers to the money you earn through employment or self-employment. It encompasses wages, self-employment earnings, and similar sources of income. In contrast, unearned income includes government benefits (e.g., Temporary Assistance for Needy Families or welfare payments), unemployment benefits, Social Security, and various forms of passive income (e.g., interest from bank accounts, dividends, rental property income)
While both types of income are generally subject to taxation, they may be taxed at different rates. For instance, in the 2022 and 2023 tax years, the federal government applies seven tax brackets to earned income, with rates ranging from 10% to 37%. These thresholds, adjusted for inflation, vary depending on your filing status as a single filer, married couple filing jointly, or head of household.
Tax Considerations
Distinguishing between earned and unearned income and correctly reporting it on your tax return, like Form 1040, is usually a straightforward process. However, for some taxpayers, there are additional considerations tied to earned income. If you receive Social Security benefits, for instance, you might have to pay income tax on a portion of these benefits if your earned income (or other income) surpasses a specific threshold. Depending on your income and filing status, either 50% or 85% of your benefits could be subject to taxation in such cases.
This becomes a critical aspect for individuals who intend to continue working after becoming eligible for Social Security benefits or are contemplating whether to delay claiming those benefits. If you’re self-employed, it’s also vital to project your anticipated earned (and other) income for the year and make quarterly estimated tax payments based on this estimation.
Failure to fulfill your tax obligations throughout the year may necessitate making up the difference when filing your tax return, potentially leading to penalties imposed by the Internal Revenue Service (IRS).
Types of Earned Income
Taxpayers can accrue various forms of earned income, and it’s possible for a single taxpayer to have multiple types of earned income simultaneously. Here are some examples of earned income types:
- Salaries/Wages: Salaries and wages stand out as the most prevalent form of earned income. These terms signify the compensation an individual receives from their employer in return for their labor. In the majority of instances, remuneration for work, whether it's based on an hourly wage or an annual salary, qualifies as earned income.
- Self-Employment Income: In a similar vein, the source of your income may not be a determining factor. Whether you are self-employed or working for another organization, both categories of income are classified as earned. This encompasses self-employed professionals such as freelancers, consultants, and small business proprietors.
- Tips and Commissions: Tips, commissions, or other variable forms of compensation represent additional payments individuals receive alongside their standard salary or wages. Tips are frequently encountered in the service sector, while commissions are typically granted to salespeople or individuals who earn a percentage of the sales they generate. These forms of income can be either regular or irregular but are generally classified as earned income.
- Bonuses: Bonuses constitute another category of non-guaranteed remuneration that individuals can receive from their employer for accomplishing specific performance targets or reaching other significant milestones. As this represents extra compensation earned through work performance, it is duly categorized as earned income.
- Honorarium: Honorariums denote payments for services rendered, such as speaking at an event, writing an article, or taking part in a convention. Since these payments are provided in exchange for a service, they are rightfully considered earned income.
- Long-term disability benefits: Long-term disability retirement benefits that are claimed before reaching the minimum retirement age can potentially be classified as earned income.
Earned Income Tax Credit (EITC)
Qualification for the Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is a refundable tax credit in the United States designed to provide financial assistance to low to moderate-income working individuals and families. It is intended to incentivize work and help alleviate poverty by offering a tax credit that increases with earned income, up to a certain limit.
Key points about the Earned Income Tax Credit (EITC) include:
Targeted at Low to Moderate-Income Workers: The EITC is primarily aimed at individuals and families with earned income within certain income thresholds. These thresholds vary depending on filing status and the number of qualifying children.
Refundable Credit: One of the significant features of the EITC is that it is a refundable tax credit. This means that if the EITC exceeds the amount of taxes owed, eligible taxpayers can receive the excess credit as a tax refund. It can provide a substantial financial boost to qualifying families.
Varied Credit Amounts: The amount of the EITC varies based on several factors, including income, filing status, and the number of qualifying children. The credit tends to be more substantial for families with more qualifying children.
Phase-In and Phase-Out: The EITC has phase-in and phase-out ranges, which means that as income increases, the credit amount gradually increases (up to a maximum) and then gradually decreases (as income surpasses the phase-out threshold).
Qualifying Children: Having qualifying children is a significant factor in determining the EITC amount. A qualifying child must meet certain criteria, including age, relationship, and residency.
No Investment Income: Individuals with significant investment income (e.g., interest, dividends, or capital gains) may not be eligible for the EITC.
Filing Requirements: To claim the EITC, taxpayers must file a federal income tax return, even if they don’t owe any taxes or are not required to file a return otherwise.
Federal and State Credits: Some states have their own earned income tax credits, which may complement the federal EITC. Eligibility and credit amounts for state-level EITCs can vary.
The EITC has been successful in reducing poverty and encouraging employment among low to moderate-income individuals and families. It is important to note that tax laws and eligibility criteria can change, so individuals who believe they may qualify for the EITC should consult with a tax professional or refer to the most recent IRS guidelines and forms to determine their eligibility and the applicable credit amount.
- Have a valid Social Security number by the due date of your tax return (includes extensions)
- Be a U.S. citizen or a resident alien all year
- Not file Form 2555 for Foreign Earned Income
- Meet certain qualifying rules if you are separated from your spouse and not filing a joint tax return
If you are not sure whether you qualify or have questions about your specific situation, seek advice from the IRS or an independent tax professional. Most of this information will also be included in any tax filing software you use.
Example of Earned Income
Imagine a taxpayer who earned a $50,000 salary from their regular day job, $10,000 bonus for their performance, $5,000 wage from their side gig, and $500 tip for that side gig. In addition, that taxpayer earned $1,000 in ordinary dividends and recognized $25,000 of capital gain distributions.
In this example, the taxpayer must calculate their earned income to appropriately their tax bill. Based on the numbers above, the only forms of earned income include:
- Salary ($50,000)
- Bonus ($10,000)
- Wages ($5,000)
- Tips ($500)
What is Un-Earned Income
Un-earned income refers to money or financial benefits that an individual receives without actively working for it. Unlike earned income, which is derived from one’s labor or services, unearned income is typically generated from investments, assets, or other sources that do not require active participation or work.
Common examples of unearned income include:
Interest Income: Money earned from interest on savings accounts, certificates of deposit (CDs), bonds, or other interest-bearing investments.
Dividend Income: Payments received by shareholders from owning stocks in a company.
Rental Income: Earnings generated from renting out real estate properties, such as apartments, houses, or commercial spaces.
Capital Gains: Profits earned from the sale of assets, such as stocks, real estate, or other investments, when the selling price exceeds the purchase price.
Royalties: Payments made to authors, musicians, artists, or creators for the use of their intellectual property, such as books, music, or artwork.
Pension Income: Retirement benefits received from employer-sponsored pension plans, individual retirement accounts (IRAs), or other retirement savings vehicles.
Annuity Payments: Periodic payments received from annuities, which are financial products that provide a series of payments in exchange for a lump sum or periodic contributions.
Social Security Benefits: Monthly payments made to retirees, disabled individuals, and survivors through the Social Security system in the United States.
Inheritance: Money or assets inherited from a deceased family member or relative.
Unearned income is generally not subject to payroll taxes like Social Security and Medicare, and the tax treatment can vary depending on the type of income, its source, and the tax laws in a particular country. It is important for individuals to understand the tax implications of their unearned income and report it accurately on their tax returns to comply with tax regulations.
How Do I Know If I Have Earned Income?
To begin, it’s essential to determine whether you received any form of income. Reflect on sources through which you earned compensation, whether it involved your time working a job or profits gained from selling goods or services.
Next, you should analyze your activities in alignment with IRS guidance manuals to ascertain whether they qualify as earned or unearned income. In a general sense, if you received payment for work performed, it typically falls under the category of earned income.
What Is the Main Difference Between Earned and Unearned Income?
The main difference between earned and unearned income lies in how they are obtained:
Earned Income:
- Definition: Earned income is the money you receive in exchange for performing services or labor, often as an employee or through self-employment.
- Source: It typically comes from activities like working a job, running a business, or providing services as a freelancer or consultant.
- Examples: Wages, salaries, tips, bonuses, commissions, self-employment income, and income from a part-time job are all forms of earned income.
Unearned Income:
- Definition: Unearned income refers to money or financial benefits received without the need for active work or labor. It is typically generated from investments, assets, or passive activities.
- Source: Unearned income often comes from sources like investments, savings accounts, dividends from stocks, rental properties, interest on loans, and inheritances.
- Examples: Interest income, dividend income, rental income, capital gains from investments, and inheritance proceeds are all examples of unearned income.
In summary, earned income is the compensation you receive for your active involvement in work or services, while unearned income is generated from investments, assets, or passive activities without requiring active labor. The tax treatment and eligibility for certain benefits or credits, such as the Earned Income Tax Credit (EITC), can differ between these two types of income. Understanding the distinction is important for tax planning and financial management.
Understanding the Taxation of Unearned Income: What You Need to Know
The taxes owed on unearned income depend on various factors, including the type of unearned income, your total income, and your tax filing status. Here’s a general overview of how taxes are typically applied to common forms of unearned income in the United States:
Interest Income: Interest income earned from savings accounts, certificates of deposit (CDs), or other interest-bearing investments is generally taxable at your ordinary income tax rate. It’s reported on your tax return, and you may receive a Form 1099-INT from the financial institution.
Dividend Income: Dividend income received from stocks and mutual funds can be taxed at different rates. Qualified dividends may receive preferential tax rates, while non-qualified dividends are taxed as ordinary income.
Capital Gains: Profits from the sale of assets like stocks, real estate, or investments can be subject to capital gains tax. The tax rate depends on whether the gains are short-term (held for one year or less) or long-term (held for more than one year). Long-term capital gains often receive lower tax rates.
Rental Income: Rental income is typically considered taxable income. You may deduct certain expenses related to the property, but the net rental income is subject to your ordinary income tax rate.
Annuity Payments: Annuity income may be partially taxable, depending on whether the annuity is purchased with pre-tax or after-tax funds. A portion of each payment may be considered a return of your principal and not subject to tax.
Social Security Benefits: Social Security benefits may be partially taxable if your total income (including other sources) exceeds certain thresholds. Up to 85% of your Social Security benefits can be subject to income tax.
Inheritance: Inheritances themselves are typically not subject to income tax. However, any income generated by inherited assets, such as interest or dividends, can be subject to tax.
It’s essential to consult the most current tax laws and IRS guidelines for your specific situation. Additionally, tax laws can change over time, so seeking advice from a tax professional or using tax preparation software can help you accurately determine the taxes owed on your unearned income and take advantage of any available deductions or credits. Your overall tax liability will depend on your total income, deductions, credits, and filing status.
What's the Difference Between Marginal and Effective Tax Rates
When it comes to annual tax filing, calculating your tax liability or potential refund is a primary concern. To gain insights into these financial outcomes, it’s crucial to grasp the distinctions between your marginal and effective tax rates. This understanding is essential for accurate tax estimation.
What Is Marginal Tax Rate?
This is the tax rate applied to your last dollar of taxable income. It represents the percentage of tax you pay on an additional dollar earned or an additional dollar of deduction. In other words, it’s the highest tax rate you face within your tax bracket. As your income increases, you may move into higher tax brackets, resulting in a higher marginal tax rate on additional income.
Example of How Marginal Tax Rate Works?
Suppose you’re a single taxpayer with a total gross income of $125,000 before applying any deductions. Without any above-the-line deductions and by claiming the standard deduction for a single taxpayer on a 2022 return filed in 2023, your total taxable income amounts to $112,050.
Once you’ve determined your total taxable income, you can refer to the IRS’s tax brackets to identify your marginal tax rate.
Following the 2022 tax brackets provided earlier, your tax calculation would look like this:
- 10% on your initial $10,275 of income: Approximately $1,028 (rounded)
- 12% on the subsequent $31,500 of income ($41,775 – $10,275): About $3,780
- 22% on the following $47,300 of income ($89,075 – $41,775): Approximately $10,406
- 24% on your remaining $22,975 of income ($112,050 – $89,075): Approximately $5,514
In this illustration, your marginal tax rate, which represents your highest tax rate, is 24%.
The total tax amount owed would be $20,728.
What Is Effective Tax Rate?
This is the average tax rate you pay on your total taxable income. It takes into account all the tax brackets you may fall into, deductions, credits, and exemptions. The effective tax rate gives you a more comprehensive view of your overall tax burden. It’s calculated by dividing your total tax liability by your total taxable income.
Examples of How Effective Tax Rates Works?
Let’s revisit the previous example to demonstrate the distinction between your effective tax rate and your marginal tax rate.
In our hypothetical scenario, we previously calculated that your federal income tax owed for 2022 was $20,728, based on a taxable income of $112,050. This results in an effective tax rate of 18.5%, calculated as $20,728 ÷ $112,050.
However, if you qualify for the $2,000 child tax credit, your annual tax liability would decrease to $18,728. This adjustment results in an effective tax rate of 16.7%, calculated as $18,728 ÷ $112,050.
Thus, while your marginal tax rate remains at 24%, your actual payment toward federal income taxes, as a percentage of your total taxable income, is 18.5% without the tax credit and 16.7% if you are eligible for it.
The Bottom Line
Understanding both your marginal and effective tax rates is a fundamental aspect of effective tax planning. This knowledge not only provides insight into the portion of your income allocated to taxes but also enables you to anticipate the financial consequences of any alterations in your taxable income.
For instance, if you anticipate receiving a bonus that could push you into a higher tax bracket, it may be prudent to explore potential income adjustments that can lower your taxable income or seek out tax credits to mitigate your tax liability.
To put this valuable information into practice, you can utilize our income tax calculator. This tool offers a more comprehensive understanding of your potential tax obligations and assists you in making informed decisions to efficiently manage your tax situation.
Understanding the Consequences of Late Tax Filing or Non-Filing
The penalty for filing your taxes late or not filing them at all can vary based on several factors, including the reason for the delay, whether you owe taxes, and how long the delay persists. Here’s an overview of the potential penalties:
Late Filing Penalty: If you fail to file your tax return by the deadline (usually April 15 in the United States), you may incur a late filing penalty. This penalty is typically 5% of the unpaid taxes for each month or part of a month that your return is late, up to a maximum of 25% of the unpaid taxes.
Late Payment Penalty: If you owe taxes but fail to pay by the deadline, you can also face a late payment penalty. This penalty is generally 0.5% of the unpaid taxes for each month or part of a month that the tax remains unpaid. The penalty can accumulate up to a maximum of 25% of the unpaid taxes.
Failure to File Penalty: If you don’t file a tax return and owe taxes, the penalty can be particularly severe. It’s typically 5% of the unpaid taxes for each month or part of a month that the return is late, up to a maximum of 25% of the unpaid taxes.
Combined Penalties: In some cases, you may face both a late filing penalty and a late payment penalty concurrently, which can result in a total penalty of up to 47.5% of the unpaid taxes.
Reasonable Cause Exception: There are certain situations in which the IRS may waive or reduce penalties if you can demonstrate “reasonable cause” for the delay. Examples of reasonable cause may include serious illness, a natural disaster, or other extraordinary circumstances beyond your control.
It’s essential to file your tax return or request an extension even if you can’t pay the full amount of taxes you owe. Filing on time or requesting an extension can help avoid the more significant penalties associated with late filing.
If you’re unable to pay your taxes in full, you may also consider setting up a payment plan with the IRS or exploring other options, such as an Offer in Compromise, to settle your tax debt.
The specific penalties and rules can vary by country, so it’s advisable to consult the tax authorities or a tax professional for guidance tailored to your situation.
What if You're Eligible for a Tax Refund?
If you’re entitled to a tax refund, the IRS doesn’t impose penalties for filing your tax return late. However, there are two compelling reasons for promptly filing your return:
Claiming your refund: Filing your tax return after the deadline could result in forfeiting your refund. According to the law, you have a three-year window to file a return and claim a tax refund. This three-year period commences on the original due date of the return. For instance, if your 2021 tax return was initially due on April 18, 2022, and you haven’t filed it yet, you have until April 18, 2025, to submit your return and secure your refund.
Initiating the statute of limitations: Generally, the IRS can audit tax returns submitted within the past three years, known as the statute of limitations. However, there are exceptions. If the IRS suspects a substantial understatement of your income—25% or more—it can extend this period by an additional three years. The countdown begins when you file your return. So, if you filed your 2019 return on July 1, 2022, the IRS has until July 1, 2025, to audit your return—or until July 1, 2028, if there was a significant income underreporting. When you delay filing, the clock never starts ticking, which means the IRS can potentially audit you five, ten, or even fifteen years later.
What Is The Estate Tax?
Estate tax, also known as inheritance tax or death tax in some regions, is a tax imposed by the government on the value of a deceased person’s estate upon their death. It is not a tax on the deceased person’s income but rather on the value of their assets and property at the time of their passing.
Key points about estate tax include:
Taxable Estate: The estate tax is typically applied to the total value of the deceased person’s assets, including real estate, investments, bank accounts, personal property, and more. Debts and certain deductions may reduce the taxable estate.
Exemption Threshold: Most countries with estate taxes have an exemption threshold, which is the value below which no estate tax is owed. Estates valued below this threshold are considered exempt. The threshold can vary widely between countries and regions.
Progressive Tax Rate: Estate tax is often progressive, meaning that the tax rate increases as the estate’s value exceeds certain thresholds. Higher-value estates generally face higher tax rates.
Exemptions and Deductions: Certain assets may be exempt from estate taxation, such as assets left to a surviving spouse or qualified charitable organizations. Deductions may also apply to reduce the taxable estate, such as funeral expenses, administrative costs, and certain debts.
Lifetime Gifting: In some tax systems, individuals can reduce their taxable estate by making gifts during their lifetime. There are usually annual and lifetime limits on the value of gifts that can be excluded from the taxable estate.
State-Level Estate Taxes: In addition to federal or national estate taxes, some countries have state-level estate taxes. These taxes may have their own exemption thresholds and rates, which can vary from state to state.
Estate Planning: Many individuals engage in estate planning to minimize their potential estate tax liability, often by using strategies such as wills, trusts, and gifts.
It’s important to note that estate tax laws and regulations can change over time, and they vary between countries and regions. The specific rules and exemptions can be complex, and individuals with substantial estates often seek the advice of estate planning professionals to ensure their assets are managed and transferred efficiently while minimizing estate tax liability.
How Estate Tax Works?
Even if your estate comprises a substantial amount of assets at the time of your passing, estate tax considerations may not apply, thanks to your lifetime gift tax exclusion. As of the 2023 tax year, the lifetime exclusion stands at $12.92 million for single filers, and for married couples, this amount increases to approximately $26 million. It is adjusted annually to account for inflation.
You have the option to utilize a portion or the entirety of your lifetime gift tax exclusion when making significant gifts during your lifetime. However, if in any given year you gift an amount less than the annual exclusion, which is $17,000 per recipient for 2023, your lifetime gift tax exclusion remains intact.
For instance, suppose you provided your child with a gift totaling $40,000, distributed evenly over the tax years 2019, 2020, 2021, and 2022. In this case, these gifts would not be counted toward your lifetime gift and tax exclusion amount.
Upon your passing, the IRS will only assess taxes on the portion of your estate that exceeds the remaining balance of your lifetime gift tax exemption at the time of your death.
What Are the Estate Tax Rates?
Once you’ve approximated the value of your taxable estate, you can determine the estate taxes that may apply. Taxable portions of an estate, which are the segments exceeding the lifetime exclusion, are subject to estate tax rates for the 2023 tax year. These rates range from 18% to 40%.
2023 Estate Tax Rates
| Taxable Portion Over | But Not Over | Amount of Taxes the Estate Will Pay |
|---|---|---|
| $0 | $10,000 | 18% of the Amount |
| $10,000 | $20,000 | $1,800 + 20% of the Amount Over $10,000 |
| $20,000 | $40,000 | $3,800 + 22% of the Amount Over $20,000 |
| $40,000 | $60,000 | $8,200 + 24% of the Amount Over $40,000 |
| $60,000 | $80,000 | $13,000 + 26% of the Amount Over $60,000 |
| $80,000 | $100,000 | $18,200 + 28% of the Amount Over $80,000 |
| $100,000 | $150,000 | $23,800 + 30% of the Amount Over $100,000 |
| $150,000 | $250,000 | $38,800 + 32% of the Amount Over $150,000 |
| $250,000 | $500,000 | $70,800 + 34% of the Amount Over $250,000 |
| $500,000 | $750,000 | $155,800 + 37% of the Amount Over $500,000 |
| $750,000 | $1 Million | $248,300 + 39% of the Amount Over $750,000 |
| $1 Million | — | $345,800 + 40% of the Amount Over $1 Million |
This table outlines the estate tax rates based on the taxable portion of the estate.
Who Is Subject to Estate Tax?
Estate tax is applicable primarily to substantial estates. With the 2023 lifetime gift and estate tax exclusion set at $12.92 million for single taxpayers and approximately $26 million for married couples, individuals with more modest assets generally do not fall under the scope of the estate tax.
It’s essential to recognize that the lifetime exclusion always comes into play unless you exceed your annual gift exclusion limit. For instance, if you provide your child with a monetary gift exceeding the annual exclusion of $17,000 for 2023, your lifetime exclusion will be reduced by the amount exceeding $17,000.
For those who consistently stay within the annual exclusion limit each year, the entire lifetime exclusion remains available to offset their taxable estate. This is why only a limited number of estates end up paying estate taxes.
States With an Estate Tax
Estate taxes are imposed at the federal level, and in addition to the federal estate tax, 12 states and the District of Columbia also have their own estate tax laws. These states include:
- Connecticut
- Hawaii
- Illinois
- Maine
- Maryland
- Massachusetts
- Minnesota
- New York
- Oregon
- Rhode Island
- Vermont
- Washington
Distinguishing Between the Estate Tax and Inheritance Tax
It’s important to note that the estate tax and inheritance tax are not identical. The primary distinction lies in who bears the responsibility for paying the tax: Estate taxes are imposed on the estate itself, whereas an inheritance tax is levied on the beneficiary who inherits the assets.
At the federal level, there is no inheritance tax, but six states have implemented inheritance taxes:
- Iowa
- Kentucky
- Maryland
- Nebraska
- New Jersey
- Pennsylvania
Notably, Maryland is the only state that enforces both an estate tax and an inheritance tax.
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