What Questions Do You Still Have About Earned Income?

Earned income is the money you receive from working, whether through a job, self-employment, or other work-related earnings. Understanding how different types of pay are classified and taxed can help you manage finances effectively and avoid surprises when filing taxes.

There are multiple ways people earn income, each with its own payment structure, tax treatment, and documentation requirements. Knowing these distinctions helps workers plan budgets, anticipate tax obligations, and ensure compliance with labor laws.

Types of Employment-Based Pay

Compensation structures vary based on job type and employer agreements. Some workers receive a fixed salary, while others are paid hourly, through commissions, or a combination of these methods. Each structure affects income stability, tax treatment, and benefits eligibility.

Salary

A salary is a fixed amount paid to an employee regularly, typically expressed as an annual figure and divided into equal pay periods, such as weekly, biweekly, or monthly. Unlike hourly wages, salaries do not fluctuate based on hours worked. This structure is common in professional and managerial roles.

In the U.S., salaried employees are classified as either exempt or non-exempt under the Fair Labor Standards Act (FLSA). Exempt employees, often in executive, administrative, or professional roles, are not entitled to overtime pay. Non-exempt salaried employees must be compensated for overtime hours worked beyond 40 per week. Many salaried positions also include benefits such as health insurance, retirement contributions, and paid leave.

Hourly Wages

Hourly employees are paid based on the number of hours they work, with rates set per hour. This structure is common in industries such as retail, hospitality, and manufacturing, where work schedules vary. Since earnings depend on hours worked, income can fluctuate due to workload changes, seasonal demand, or employer scheduling.

As of 2024, the federal minimum wage in the U.S. is $7.25 per hour, though many states and cities mandate higher minimum wages. Employers must comply with the highest applicable wage requirement. Hourly employees are entitled to overtime pay when they work more than 40 hours in a workweek, as required by the FLSA. This overtime pay, calculated at 1.5 times the regular hourly rate, can significantly increase earnings.

Overtime and Shift Pay

Employees who work more than 40 hours in a workweek qualify for overtime pay at 1.5 times their regular hourly wage. Some states have additional requirements, such as daily overtime for hours worked beyond eight in a single day. Industries like healthcare and emergency services may have specific overtime structures outlined in collective bargaining agreements or state labor laws.

Shift differentials provide extra pay for employees working non-traditional hours, such as late-night or weekend shifts. These payments are common in industries that require 24/7 operations, including healthcare, transportation, and security. For example, a hospital nurse working the night shift might earn an additional $2 to $5 per hour beyond their base pay. While not federally mandated, shift differentials help attract workers to less desirable shifts.

Self-Employment and Freelance Pay

Independent workers, including freelancers, consultants, and small business owners, earn income outside traditional employer-employee relationships. Instead of receiving a fixed paycheck, they generate earnings through client payments, contract work, or business revenue. This structure offers flexibility but requires careful tax management.

Unlike employees who have taxes withheld from their paychecks, self-employed individuals must handle their own tax obligations. The IRS requires self-employed individuals to file a tax return if they earn $400 or more in net self-employment income. They must also pay self-employment tax, which covers Social Security and Medicare contributions. As of 2024, this tax is 15.3% of net earnings, though half of it can be deducted when calculating taxable income.

Managing cash flow is another challenge, as income can be unpredictable. Many freelancers establish separate business bank accounts, set aside a percentage of earnings for quarterly estimated tax payments, and track deductible expenses such as office supplies, software subscriptions, and business-related travel. These deductions help lower taxable income.

Tips, Gratuities, and Commissions

Workers in industries like restaurants, hospitality, and personal services often earn a significant portion of their income through tips. These voluntary payments from customers are considered taxable income and must be reported to the IRS if they exceed $20 in a month from a single job. Employers must withhold payroll taxes on reported tips, and some businesses use tip pooling arrangements to distribute gratuities among staff.

Commissions are performance-based earnings, typically seen in sales roles where compensation is tied to revenue generation. Real estate agents, stockbrokers, and retail salespeople often receive commissions as a percentage of sales or deals closed. Some employees earn solely on commission, while others receive a base salary plus commission. Since commission payments can be delayed due to contract terms or payment processing, budgeting can be challenging.

Bonuses function similarly to commissions but are tied to broader performance metrics, such as company-wide revenue goals or individual benchmarks. Unlike standard wages, bonuses and commissions may be subject to supplemental tax withholding, which the IRS sets at a flat rate—22% for amounts up to $1 million as of 2024. This withholding rate affects take-home pay, making it important to plan for large commission or bonus payouts.

Requirements for Supporting Documentation

Maintaining accurate records is essential for verifying income, meeting tax obligations, and ensuring compliance with financial regulations. The IRS requires sufficient documentation to substantiate reported income, making it necessary to retain specific forms, receipts, and statements.

For contract-based work, signed agreements outlining compensation terms serve as primary documentation. Independent contractors and gig workers often receive Form 1099-NEC from clients who pay them $600 or more in a tax year, but income below this threshold must still be reported. Bank statements and electronic payment records help reconcile earnings, particularly for those receiving payments from multiple sources or digital platforms like PayPal or Venmo.

Employees earning variable compensation, such as bonuses or incentive pay, should retain payroll statements and employer-issued documents like Form W-2, which details total taxable earnings and withheld taxes. Pay stubs provide a breakdown of gross pay, deductions, and net income, allowing workers to identify errors and request corrections from payroll departments.

Adjustments and Exclusions

Not all earned income is taxed the same way. Certain adjustments and exclusions can reduce taxable earnings and lower overall tax burdens.

Self-employed individuals can deduct business expenses related to generating income, such as home office costs, professional equipment, and travel expenses. These deductions reduce net earnings and self-employment tax obligations. Contributions to retirement accounts like a Simplified Employee Pension (SEP) IRA or a solo 401(k) are also deductible, providing both immediate tax savings and long-term financial benefits.

Some forms of compensation are excluded from taxable income. Employer-provided benefits, such as health insurance premiums and tuition reimbursement, are often exempt from federal income tax. Military combat pay and certain disability payments may also be excluded, allowing individuals to retain more of their earnings.

Filing Impacts Based on Income Composition

The type of income earned affects tax filing requirements, potential deductions, and overall financial planning. Workers with multiple income streams must ensure proper tax withholding and estimated payments to avoid penalties.

Employees with only W-2 wages typically have taxes withheld automatically, simplifying the filing process. However, those earning commissions, bonuses, or tips may experience fluctuating withholdings, leading to either underpayment or overpayment of taxes. Adjusting Form W-4 with an employer can help align withholding amounts with actual tax obligations.

Self-employed individuals and freelancers must calculate and pay estimated taxes quarterly. Failure to make these payments on time can result in penalties and interest charges. Keeping detailed records of income and deductible expenses helps streamline tax preparation and ensures compliance with IRS regulations.