If you’ve put your money to work for you in savings accounts, stocks or other investments, your gross income for the year isn’t limited to just your earned income. Your gross income includes all of your income potentially subject to income taxes whether it is earned or unearned income. On the bright side, you might be able to reduce your taxable income by taking advantage of various deductions.
Earned Income Defined
Earned income only includes the money that you make from working, such as your wages, salaries, commissions, bonuses and net self-employment income. If you get paid by other means than a paycheck, your earned income also includes the fair market value of whatever you receive. For example, if you get paid in groceries each month, your earned income includes the fair market value of those groceries. If you’re self employed, you get to reduce your total earned income by the business expenses you can claim on Schedule C. Alternatively, if you didn't work at all, but you had investment income or interest income, your gross income consists entirely of unearned income. Usually, your gross income includes both earned income and unearned income.
Significance of Earned Income
Uncle Sam rewards people who have earned income with certain tax breaks and the ability to take advantage of IRAs. To contribute to an IRA, you must have earned income equal to or greater than your contribution. For example, if you have $100,000 of taxable unearned income, such as stock gains, but you don’t have any earned income during the year, you can’t contribute to an IRA for the year. Additionally, only earned income can be used to qualify for the earned income tax credit.
Your gross income refers to all of your income for the year that is subject to income taxes. Without first figuring your gross income, you can't figure out your taxable income. Many people have interest from bank accounts, investment income or rental income. If you have investment income from assets you’ve held for longer than one year, the gains are long-term capital gains, which are taxed at a lower income tax rate. As of 2012, the maximum long-term capital gains rate is 15 percent.
Your taxable income refers to the amount of money that is subject to taxes after reducing your gross income by the value of your deductions and exemptions. Deductions allow you to reduce your gross income by the amount of various deductible expenses. Exemptions allow you to reduce your gross income by a specified amount for each dependent you claim, including yourself. As of 2012, each exemption reduces your gross income by $3,800. Tax credits function differently in that they don’t affect your taxable income for the year. Instead, tax credits directly reduce the amount of tax you owe.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."