What Is Earned Income?

What is earned income? I was trying to figure this out the other day. Here's how the IRS defines it:

What is Earned Income?

Earned income is anything you can do with a shovel. That's the image I get. If you can shovel your way to your earnings, it is earned income.

Farmers use shovels. Farming is earned income. If you are a contractor, you might occasionally use a shovel. General contractors, who own their won business, have earned income.

Sold stock in the stock market at a profit? No earned income there. No need for a shovel either. Earned interest on your bank account? That's not earned income either.

The shovel analogy only goes so far. If you work in an office pushing a pen, that too is earned income. In fact anything that you get W-2 wages for is earned income.

In terms of the tax code, earned income seems to show up in two places:

1. On the W-2 form your employer sends you
2. On Schedule C (business income) that you fill out

So whether you own your own business, or someone pays you to help them with theirs, it is earned income.

What is not earned income? If you sell that old Vincent Van Gogh painting you've been storing in your attic, that is not earned income. That's a capital gain.

So anything that becomes more valuable over time and that you sell for a profit is not earned income. At least, that's how I understand it.

In terms of the tax code, Schedule B (interest and dividends) and Schedule D (capital gains) are not earned income.

Even though the shovel analogy I started with in not perfect, it still helps me understand earned income. Earned income is grunt work. If you have to sweat a little bit to earn it, it's almost certainly earned income.

Flipping burgers over a hot stove is earned income. Trading stocks in your stock brokerage account while sitting in front of your computer is not earned income.

What if you are a soldier? Soldiering is definitely grunt work. And it is definitely earned income.

The guiding principle that seems to govern earned income is labor. If your dollars are from labor, and not from luck or circumstances, it is earned income. Even if you make your own luck, it is not earned income

I have to believe that the whole concept of earned income gets a little bit murky at times. Surely someone who owns a retail store that buys items at cost and sells them for a profit has earned income.

But what about a retail store that buys and sells antiques? I would imagine that that is earned income as well. I'm not an expert. I'm just guessing.

At what point the buying and selling of items becomes a retail operation and not a capital gain is unclear to me. If that's your question too, you should probably ask someone who knows far more than I do.

When I get into trouble with tax issues, I consult a tax professional.

Update: May 13, 2014

I just came across the most succinct definition of earned income I've seen so far:

Earned income includes wages, salaries, tips, professional fees, and other compensation received for personal services you performed. It also includes any amount received as a scholarship that you must include in your income. Generally, your earned income is the total of the amount(s) you reported on Form 1040, lines 7, 12, and 18, minus the amount, if any, on line 27.

Finally! A simple definition for earned income. The paragraph above is quoted from the 2013 instructions for Form 1040. Specifically, it is from the Standard Deduction Worksheet for Dependents, a worksheet associated with line 40 of Form 1040, long form. This worksheet is found on page 39 of the instructions

I like this definition for earned income because it is expressed in terms of Form 1040 line numbers. In my own mind, the above definition translates to a simple arithmetic formula:

1. Add wages (line 7)
2. Add business income (line 12)
3. Add farm income (line 18)
4. Subtract the deductible part of self-employment tax (line 27)

The result is your total earned income

While the above definition is not sufficient for all people, it does give general insight into what earned income is. Furthermore, this definition is probably sufficient for most wage earners and most self-employed people. In fact, most wage earners can probably skip the last 3 steps and just focus on step 1, add wages. For a wage-earner, the only component of their earned income is, I'm guessing, the figure found on their W-2, their wages for the year.

For some of us, earned income is a bit more complex. Here's another IRS paragraph that gives further insight into what earned income is:

Earned income includes net earnings and gains from the sale, transfer, or licensing of property you created. However, it does not include capital gain income. If you were a more-than-2% shareholder in the S corporation under which the insurance plan is established, earned income is your Medicare wages (box 5 of Form W-2) from that corporation.

The above paragraph is from the Form 1040 instructions for 2013. It is from the Self-Employed Health Insurance Deduction Worksheet found on page 31 of the instructions. The worksheet calculates the amount for line 29 on Form 1040.

The above paragraph appears to me to be directed at people who own their own private corporation, a so-called S Corporation. I do not own my own corporation so this does not apply to me.

However I do find the part about property you create helpful. It sounds to me like an artist who paints a painting and sells it has earned income, not a capital gain. This is only common sense.

Later, however, the person who bought it might sell it for a capital gain after the art appreciates in the marketplace as time goes by.

Again, it appears that the essential component of earned income is grunt work. In this case, the artist's shovel is his paintbrush.

Ed Abbott