Paying Taxes on Earned Income

One of the realities of life is the requirement to pay taxes. As citizens, we pay taxes to the government, and the government is supposed to provide us with various services. (What, exactly, taxes are used for, as well as how much we should pay in taxes, are debates for another day.) We pay taxes on different types of income, and the type of income you are probably most familiar with paying takes on is earned income.
Paying Taxes on Earned Income

What is Earned Income?

It is helpful to understand what earned income is. In its most basic sense, earned income is compensation you receive for what we consider “work.” This includes income from a business you own, your salary, commissions, hourly wage, bonuses and tips (yes, you are supposed to report tips). The opposite of earned income is unearned income.

Unearned income is represented by what you receive from putting your money to work for you. This includes interest earned from investments, dividends, and rental property income. Unearned income can also be prizes won or gambling earnings — the type of income that goes on line 21 of your Form 1040.

How You are Taxed on Your Earned Income

For tax purposes, the U.S. population is divided up into income brackets. Each bracket represents a range of incomes. Each bracket also has a different rate attached to it. For 2010, the brackets include 10%, 15%, 25%, 28%, 33% and 35%. If the Bush tax cuts are allowed to expire on schedule, then the top two brackets will be 36% and 39.5%. However, that percentage isn’t figured on your entire earned income. Instead, deductions are used to reduce your income so that what you pay taxes on is lower than your earned income. (It is important to note that, for figuring your total taxable income, your “other” income from line 21 will be added to your earned income. Your income from long-term investment earnings might be taxed differently from the rest of your income.)

After the income from different sources is added up, you have the chance to take deductions. You can itemize your deductions, adding up each deductible item from charitable contributions to education expenses to mortgage interest, and then subtract that from your income total. There are other deductions, like moving expenses and part of any self-employment tax you pay, that are also deducted. So, if you have $60,000 in earned income, no “other” income and $15,000 in deductions, your taxable income would be $45,000. The percentage of your income paid in taxes would be applied to that lower amount.

Earned Income Credit

In order to help you pay your tax requirement, you might be able to apply credits. A credit is applied after the amount of taxes you owe has been figured. Credits are more valuable than deductions because they are a dollar for dollar reduction of in what you owe. It’s like having a gift card and applying that amount to your tax obligation. One of the credits you might be eligible for is the Earned Income Credit (EIC).

The EIC is a special credit that you can get if you have earned income, and if you meet certain qualifications. There is an income requirement, and if you do not have children, there are additional requirements to meet in order to qualify for the EIC.

For most people, earned income is the basis for figuring their tax obligation. It is a good idea to understand what earned income is, and also to understand how you can reduce your overall taxable income with the help of deductions — as well as use credits to reduce your tax obligation. Speaking with a tax professional can help you gain a better understanding of how taxes work.?

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