What it means
The simple test for earned income is whether you had to do something to receive it. If an employer pays you for your time, or a client pays you for your services, the money is earned.
If your savings pay interest while you sleep, the money is not. Earned income usually includes salary and hourly wages, overtime, commissions, bonuses, tips and taxable fringe benefits.
For people who work for themselves, it includes net earnings from self-employment, which means business profit after deducting allowable expenses. Gross revenue alone is not earned income for a sole trader.
Many tax and pension systems treat earned income differently from other income. Retirement account contributions are often limited by how much you earn from work, and some tax credits are available only to people with earned income.
The details vary by country and change over time, so you should always check the current rules with the relevant tax authority. For a business owner, the question is often how to draw money from a company.
Salary is earned income, whereas dividends paid by the company are generally treated as investment income. The mix between the two affects personal tax, pension entitlement and social contributions, which is why founders ask their accountants about it.
A common nuance is that some income sits in a grey area. Rental income, royalties and income from a business in which you do not take an active part may be classed as unearned, but the rules differ between jurisdictions.
Pension payments and unemployment benefits are usually not treated as earned income either. For employees the practical evidence of earned income is the payslip and the annual tax summary, while self-employed people rely on their accounts and tax return.
Keeping these records tidy matters, because lenders, tax authorities and pension providers may all ask for proof. Owners of small companies should also remember that the figure used by one body may differ from the figure used by another.
In practice
Real-world examples
Example 1
A software engineer receives a $95,000 salary and a $10,000 annual bonus, and also earns $3,000 in dividends from shares she owns. Her earned income is $105,000, while the dividends count as investment income. When she plans her retirement contribution, her adviser bases the limit on the $105,000.
Example 2
A self-employed photographer invoices $60,000 in a year and has $22,000 of allowable expenses. His net self-employment earnings, and therefore his earned income, are $38,000. He cannot use the full $60,000 when applying for a mortgage or working out his pension contribution.
Example 3
A retiree receives a $30,000 pension and $8,000 of interest from savings. Neither counts as earned income, so she cannot make certain contributions that require income from work. Her adviser suggests a part-time consulting role to restore that eligibility.
Think of it
Earned income is money you work for-wages and business profits, not investment returns.
Formula
Calculation
Earned income = Wages and salary + Bonuses and commissions + Tips + Net self-employment earnings
Suppose a marketing manager earns a salary of $70,000 and receives a bonus of $8,000. She also freelances in the evenings, earning $15,000 in fees and incurring $3,000 of allowable business costs, so her net self-employment earnings are 15,000 - 3,000 = $12,000.
Earned income = 70,000 + 8,000 + 12,000 = $90,000.
Her $2,500 of bank interest and $1,500 of dividends are not earned income, so they are left out of the total.Case study
Seen in the real world
Calloway Studio is an illustrative, fictional design business owned by one founder, who paid herself a small salary of $20,000 and took the remaining profit of $100,000 as company dividends to reduce social contributions. At first the plan looked sensible for tax.
When she applied for a mortgage, the lender asked for evidence of earned income and assessed her on the $20,000 salary rather than the $120,000 she had actually taken. She was offered a much smaller loan than she expected.
Her accountant then restructured her pay to include a higher salary of $60,000 alongside dividends. The illustrative lesson is that how income is labelled affects borrowing, pensions and tax together, so it should be planned deliberately.
Watch out
Common mistakes
- Assuming all money received counts as earned income, including interest, dividends and capital gains.
- Using gross business revenue instead of net profit when calculating the earned income of a self-employed person.
- Assuming the definition is the same in every country, when tax authorities set their own rules.
Questions
People also ask
Are dividends earned income?
Generally no, because dividends are a return on owning shares, although the rules differ between jurisdictions and for owner-managed companies.
Does a bonus count as earned income?
Yes, because a bonus is paid for work done for an employer and is normally taxed in the same way as salary.
Why does earned income matter for retirement savings?
Many systems limit tax-favoured pension contributions to the amount you earn from work, so having no earned income can restrict how much you may contribute.
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