Whether earned income is gross or net depends on how you earn it. Employees report taxable wages from Box 1 of the W-2, which is a gross figure but one that already has pretax items like 401(k) contributions removed. Self-employed workers report net earnings — gross receipts minus business expenses — and for the Earned Income Tax Credit they subtract another half of their self-employment tax on top of that.1Office of the Law Revision Counsel. 26 U.S.C. § 32
What Employees Report
For a W-2 employee, the starting figure is Box 1: taxable wages, tips, and other compensation.2IRS. Publication 596 – Section: Earned Income This is not your full paycheck total and it is not your take-home pay. It sits between the two.
Box 1 excludes elective deferrals such as employee contributions to 401(k) or 403(b) plans, so those pretax retirement dollars are already stripped out before the number reaches your return.3IRS. W-2 and W-3 Instructions – Section: Box 1—Wages, tips, other compensation Amounts you pay out of after-tax wages, like union dues, do not reduce Box 1. The federal definition of earned income under 26 U.S.C. § 32 tracks what is includible in gross income, which is why the Box 1 figure — not your gross annual salary and not your net deposit — is what the Earned Income Tax Credit relies on.1Office of the Law Revision Counsel. 26 U.S.C. § 32
What Self-Employed Taxpayers Report
If you work for yourself, earned income is a net figure. On Schedule C you subtract ordinary and necessary business expenses from your total revenue to reach net profit.4Office of the Law Revision Counsel. 26 U.S.C. § 1402 Reporting gross receipts would overstate your earned income; reporting take-home cash after personal spending would understate it. The number is what’s left after legitimate business costs.
For EITC purposes, one more adjustment is required. Under 26 U.S.C. § 32, self-employment earnings must be reduced by the deduction allowed under Section 164(f), which is one-half of self-employment tax.5Office of the Law Revision Counsel. 26 U.S.C. § 164 You calculate the tax and the adjustment on Schedule SE. The result — net profit minus half of SE tax — is your statutory earned income for the credit.
Payments That Count and Payments That Don’t
Compensation that is includible in gross income generally counts as earned income. That includes:2IRS. Publication 596 – Section: Earned Income
- Wages and salaries
- Cash tips reported to an employer
- Professional fees and sales commissions
- Taxable benefits from an employer’s disability retirement plan received before minimum retirement age
Money that isn’t payment for current work is excluded. Interest, dividends, pension and annuity payments, and unemployment insurance benefits are not earned income.6IRS. Publication 596 – Section: Income That Is Not Earned Income Non-taxable employee pay generally does not count either, with limited exceptions.
Social Security Uses Different Rules
The gross-versus-net answer above governs federal income tax and the EITC. Supplemental Security Income works differently. The Social Security Administration counts wages before deductions, and it counts self-employment earnings as net earnings, under 20 C.F.R. § 416.1110.7Social Security Administration. 20 C.F.R. § 416.1110 The agency then applies a specific set of exclusions in a fixed order to arrive at “countable earned income,” which is what actually affects SSI benefits.8Social Security Administration. 20 C.F.R. § 416.1112 If you are reporting income to SSA rather than the IRS, don’t assume the tax figure carries over unchanged.