Earned Income

Earned income is pay for personal services. For the earned income tax credit, the IRS counts the taxable wages, salaries and tips in box 1 of your W-2, tips you didn’t report to your employer, household-employee pay, gig work such as rideshare or freelance jobs, net profit from a business, farm or ministry, taxable union strike benefits, and certain disability benefits received before minimum retirement age. Members of the military can choose to count nontaxable combat pay.

Everything else is unearned: interest, dividends and capital gains, pensions and annuities, Social Security, unemployment benefits, alimony and child support. Rent from real estate usually falls here too, because the tax code leaves it out of self-employment earnings unless you are a real estate dealer. Earned and taxable aren’t the same thing, either: gifts and life insurance proceeds are non-taxable income that nobody earned, while combat pay can be earned without being taxed.

IRA eligibility uses “taxable compensation”, which adds taxable alimony under divorce agreements signed before 2019 and taxable non-tuition fellowship or stipend payments for graduate study, but leaves out deferred compensation and anything excluded as foreign earned income. For the self-employed, earned income is net profit after business expenses, not revenue, and self-employment tax applies once net earnings reach $400.

Earned income carries two federal taxes. It runs through the ordinary income tax brackets, and it also pays Social Security and Medicare tax: 7.65% of an employee’s wages, with the 6.2% Social Security part stopping at $184,500 in 2026, or 15.3% on 92.35% of self-employment profit. A 0.9% Additional Medicare Tax applies above $200,000 of wages ($250,000 on a joint return). That second layer is why a raise adds less to your take-home pay than to your salary.

Unearned income never pays payroll tax. Interest, pensions and traditional IRA withdrawals are taxed at ordinary rates, but qualified dividends and long-term gains get their own 0%, 15% and 20% rates, and in 2026 a single filer pays 0% on them while taxable income stays under $49,450. Higher earners pay the 3.8% net investment income tax on investment income instead, above $200,000 of MAGI for single filers and $250,000 for joint filers. The two surtaxes don’t overlap, because wages and self-employment profit are left out of the net investment income tax.

Dollar for dollar, then, work is often taxed more heavily than investment income, as the example below shows. What the extra tax buys is Social Security coverage, which no amount of unearned income can earn.

Several rules look at earned income specifically, not at your total income. That is why a household living comfortably on dividends and account withdrawals can be shut out of an IRA contribution, while a teenager with a summer job qualifies for one. Each rule uses its own version of the definition above, so a type of pay that counts for one may not count for another. The rules most people run into, with their 2026 figures, are these:

Earned income is also what builds Social Security. In 2026 every $1,890 of covered earnings buys one credit, up to four a year ($7,560), and 40 credits qualify you for a retirement benefit. The benefit itself is based on your 35 highest years of indexed earnings, so a year with no earnings counts as a zero in that average.

If you claim before full retirement age and keep working, the earnings test withholds $1 of benefits for every $2 you earn above $24,480 in 2026, or $1 for every $3 above $65,160 in the year you reach it. Only wages and net self-employment earnings count toward it. A pension, IRA withdrawals, rent and investment income don’t, however large.

For tax purposes, retirement is the year earned income stops. Payroll tax drops out of the budget, IRA contributions end unless a working spouse’s pay supports them, and the brackets fill with withdrawals and benefits instead. That is why part-time work in early retirement does more than pay bills: it keeps IRA eligibility alive, adds credits, and can replace a low or zero year in the benefit formula.

Most errors come from treating any taxable income as earned income, or from assuming the label stops mattering once the return balances. It matters most for contributions and credits. An IRA contribution without enough compensation behind it is an excess contribution that has to come back out to avoid a penalty, and a credit claimed on the wrong kind of income can be reversed later. Four mistakes come up again and again: