Earned Income Credit

The earned income credit is designed to assist the low-income worker with or without qualifying children by providing a dollar-for-dollar reduction of taxes owed and, by virtue of its standing as a refundable credit, a subsidy just in case the earned income credit is greater than tax liability.

A worker qualifies for the if he or she satisfies the following conditions:

  1. The worker must have earned income.
  2. The worker’s income from investments must be $2,900 or less.
  3. The worker cannot file for a foreign earned income exclusion.
  4. For the tax year in question, the worker’s principal residence is in the U.S. and the worker lives at this residence for more than six months.
  5. The married worker cannot file a separate return. However, a worker who lives apart from his or her spouse for the last six months of the tax year can file as head of household and claim the credit.
  6. If the worker is single and doesn’t have qualifying children, then the worker must be at least 25 but under age 65 at the end of the tax year; but if the worker is married without qualifying children, then only one spouse is required to meet this age test.
  7. The worker or worker’s spouse (if married) cannot be claimed as another person’s dependent or qualifying child.
  8. The worker, worker’s spouse (if married), and qualifying children must have valid Social Security or tax identification numbers.
  9. The worker must be a U.S. citizen or a resident alien. A single nonresident alien is not eligible for the credit. Yet a nonresident alien married to a U.S. citizen or resident can claim the credit but only if the couple makes an election to have all worldwide income subject to U.S. tax.

Click on for more information on qualification standards for the credit.

For purposes of the earned income credit, investment income comprises net capital gain income and net passive income as well as interest, dividends, tax-exempt interest, and non-business rents and royalties. In contrast, income that qualifies for the credit, namely, earned income, includes wages, salaries, tips, commissions, compensation for personal services, professional fees, union strike benefits, long-term disability benefits received before minimum retirement age, combat zone pay otherwise excluded from income if recipient chooses to treat it as earned income for the purpose of figuring the earned income credit, and net earnings from self-employment reduced by one-half of taxpayer’s self-employment tax. Earned income does not include welfare and Social Security benefits, workers’ compensation, unemployment compensation, pensions or annuities, alimony, veterans’ benefits, and taxable scholarships or fellowships not reported on Form W-2.

In 2007, the earned income credit ranges from $428 for a worker without qualifying children to $2,853 (worker has one qualifying child) and $4,716 (worker has two or more qualifying children). Being earmarked for low-income workers, the earned income credit is subject to phase out as adjusted gross income (AGI) increases but at a rate that varies according to filing status and the number of qualifying children a worker can claim.

For those with married filing jointly (MFJ) status and one qualifying child, the phase out or elimination of the earned income credit starts at $17,400 AGI and is complete when AGI reaches $35,241. For those with MFJ status and two or more qualifying children, the phase out of the earned income credit ranges from $17,400 to $39,783 AGI.

For single, head of household, and qualifying widow(er) filers with one child, the phase out of the earned income credit begins at $15,400 AGI and is complete when AGI is $33,241. If these filers have two or more qualifying children, the earned income credit phase out ranges from $15,400 to $37,783 AGI.

For workers without children, the earned income credit phase out ranges from $7,000 ($9,000 MFJ) to $12,590 AGI ($14,590 MFJ).

After figuring earned income, the worker then looks up the amount of his or her available credit on an earned income credit table provided by the Internal Revenue Service.

Example: Susan is age 35 and married but hasn’t lived with her husband since May 2006. She supports two children–an eight-year-old son and a six-year-old daughter–who live with her full time. Her only income in 2007 is a salary of $26,000 and she files as head of household. Turning to page 46 of the (pdf file), Susan’s salary is on the line, At least $26,000 but under $26,050, under the column, If the amount you are looking up from the worksheet is–, and her credit is $2,476, appearing under the column, Single, head of household, or qualifying widow(er) and you have–Two children. Confirm this result and try others with an .

For purposes of the earned income credit, an individual is a qualifying child if he or she meets all the following requirements:

There is no income test for a qualifying child–the individual can provide over 50% of his or her support and still be claimed as worker’s qualifying child.

If an individual is a qualifying child of more than one worker, the following rules apply:

Finally, a worker can fill out Form W-5 and receive the earned income credit in advance; click on the link (pdf file) for details.

Additional relevant articles on the earned income credit are listed below:

Many happy returns, Roger

Dependent Care Credit

The child and dependent care credit (hereafter abbreviated as dependent care credit), a nonrefundable credit that can be taken against regular and alternative tax liability, provides relief to those able to work (or look for work) only if care, at a price, is provided for their dependents. Like other tax credits, the dependent care credit provides a 100% after-tax savings for each dollar of credit a taxpayer is able subtract from income tax liability; deductions, on the other hand, deliver an after-tax savings equal to the taxpayer’s marginal tax rate (at present, the highest marginal tax rate for individual taxpayers is 35%). In short, credits are more valuable than deductions. Unfortunately, there is no carryover for any unused dependent care credit.

Eligible taxpayers can take a credit of up to 35% of employment-related (pdf file) for qualifying individuals, where the total of employment-related expenses is limited to the taxpayer’s earned income. (Note: Earned income includes wages, salaries, professional fees, tips, and other payments for personal services but not interest and dividends.) Expenses incurred during the time a taxpayer is able to secure, or search for, gainful employment only if others are paid to care for taxpayer’s dependents are classified as employment-related expenses for purposes of the dependent care credit. Gainful employment includes the obvious such as working for others part- or full-time or being self-employed but not volunteer work at nominal pay. In addition, the Internal Revenue Code is written in a way that prevents a double tax benefit, that is, payments received by a taxpayer from an employer-provided are subtracted from the total of expenses available for the dependent care credit. Click on (pdf file) for a worksheet that helps a taxpayer optimize his or her tax situation via a comparison of the dependent care credit with an employer-provided flexible spending account. (Note: IRS Form 2441–Child and Dependent Care Expenses–and related instructions, two vital documents for those investigating the dependent care credit, have been posted to my Tax Forms page on the navigation menu above.)

Dependent care expenses attributable to any part of the year in which a taxpayer is not working or looking for work are not eligible for the dependent care credit. Put differently, only dependent care expenses allocable to the time during which a taxpayer is actually employed or looking for gainful employment qualify for the credit.

Expenses do not qualify for the dependent care credit if paid to (1) a person the taxpayer can claim as a dependent, (2) taxpayer’s spouse, or (3) taxpayer’s child who is under age 19 at the end of the tax year. In addition, no credit is allowed for the cost of sending a child or other dependent to an overnight camp.

A taxpayer must file a joint return if married in order to claim the dependent care credit. (Note: A married taxpayer providing a principal place of abode for a qualifying dependent but living apart from his or her spouse for the last six months of the tax year is considered unmarried and qualifies as a head of household filer for purposes of the dependent care credit). In the case of a married couple, the total of employment-related expenses eligible for the credit can be no more than the earned income of the lower-earning spouse. More important, if one spouse is not working then the married couple cannot take the dependent care credit. However, just in case a nonworking spouse is a full-time student for at least five calendar months or disabled and the couple has one qualifying dependent, federal law, for the sole purpose of calculating the earned income of the lower-earning spouse, assigns to the nonworking spouse earned income of $250 per month each month the spouse is disabled or attends school ($500 per month if the couple has two or more qualifying dependents) thus making the couple eligible for the credit. While this exception creates earned, but not taxable, income for the unemployed spouse by statutory maneuver, it does not apply when both spouses are unemployed.

Since the credit addresses only a fraction of total dependent care costs necessary for gainful employment, the maximum amount a taxpayer can write off is $1,050 for the care of one qualifying dependent ($3,000 x 35%) and $2,100 for two or more qualifying dependents ($6,000 x 35%). The top rate of 35% is reduced by one percentage point for each $2,000 increment, or portion thereof, of adjusted gross income (AGI) above $15,000 and bottoms out at 20% for taxpayers with AGI greater than $43,000. An increment of AGI greater than $2,000 causes a two-bracket jump thereby reducing the fraction of available dependent care credit by two percentage points. For example, a taxpayer with AGI of $17,300, an AGI producing an increment $2,300 above the $15,000 threshold, jumps not one but two brackets, landing in the $17,001-to-$19,000 bracket and its smaller proportion of expenses (33% to be exact) open to the dependent care credit. (But click on (pdf file) for a brief examination of why the dependent care credit may not work for married couples and other important shortcomings of the credit.)

To complete the list, the following percentage of allowable employment-related expenses may be claimed as a dependent care credit depending on the taxpayer’s AGI: If taxpayer’s AGI is not more than $15,000, then 35% of employment-related expenses may be claimed as a credit; $15,001 to $17,000 AGI, then 34%; $17,001 to $19,000 AGI, 33%; $19,001 to $21,000 AGI, 32%; $21,001 to $23,000 AGI, 31%; $23,001 to $25,000 AGI, 30%; $25,001 to $27,000 AGI, 29%; $27,001 to $29,000 AGI, 28%; $29,001 to $31,000 AGI, 27%; $31,001 to $33,000 AGI, 26%; $33,001 to $35,000 AGI, 25%; $35,001 to $37,000 AGI, 24%; $37,001 to $39,000 AGI, 23%; $39.001 to $41,000 AGI, 22%; $41,001 to $43,000 AGI, 21%; and, if taxpayer’s AGI is $43,001 or higher, then 20% of eligible expenses may be claimed as a credit.

An individual qualifies for the dependent care credit under the following circumstances:

The non-exhaustive list below identifies several employment-related expenses (to repeat: expenses necessary for gainful employment, or job search activities, of a taxpayer) that qualify for the dependent care credit:

  1. Wages and taxes paid in connection with household services performed by a full-time, live-in employee for the benefit of taxpayer’s qualifying dependent; in this type of arrangement, the taxpayer, as employer, may be required to pay employer’s, and withhold employee’s, share of FICA and federal and state unemployment taxes;
  2. Services for taxpayer’s qualifying dependent or disabled spouse at a properly licensed outside dependent care center provided the individual in question regularly spends at least eight hours a day in the taxpayer’s home;
  3. Payments to a babysitter, cook, housekeeper, maid, etc. for household services that benefit taxpayer’s qualifying dependent, including the cost of providing meals and lodging for any in-home provider;
  4. Nursery school and kindergarten costs, but any separable educational benefits must be subtracted from the total of qualifying expenses; and
  5. The cost of a special school program.

Refer to the list of relevant articles below for more information about the dependent care credit:

Many happy returns, Roger

Child Tax Credit

Taxpayers can take a $1,000 tax credit through 2010 for each qualifying child under age 17. Except for taxpayers who qualify for the Additional Child Tax Credit (see below), the is nonrefundable and taken against the sum of regular and alternative minimum tax (AMT) liability. The difference between refundable and nonrefundable tax credits is important as refundable credits, unlike their nonrefundable cousins, can be used to offset taxes other than the income tax and reduce or eliminate the recapture of other tax credits.

The order of personal tax credits is important in the case of the child tax credit. Specifically, nonrefundable personal credits must be taken in the following order:

  1. Credit for child and dependent care expenses;
  2. Credit for the elderly or the disabled;
  3. Education credits, that is, Hope and Lifetime Learning Credits;
  4. Residential energy credits;
  5. Foreign tax credit;
  6. Child tax credit;
  7. Retirement savings contributions credit;
  8. Home mortgage interest credit;
  9. District of Columbia first-time homebuyer credit;
  10. Qualified adoption expenses credit;
  11. Alternative motor vehicle credit; and
  12. General business credit.

The child tax credit is subject to phase out when modified adjusted gross income (AGI) is over $75,000 for head of household filers, single taxpayers, and surviving spouses; $110,000 for taxpayers married and filing jointly; and $55,000 for taxpayers married and filing separately. (Note: Modified AGI is AGI increased by the following items: student loan interest deduction, tuition and fees deduction, foreign earned income exclusion, foreign housing deduction or exclusion, deduction for domestic producers, and several other items not relevant to the discussion in this article.) The $1,000 credit is reduced or phased out by 5% for each $1,000 increment of AGI above the threshold.

Example 1: Assuming only the existence of the child tax credit and sufficient tax liability to extinguish it, a single taxpayer with two qualifying children under age 17 and AGI of $80,400 would be able to take a credit of $700 for each child, or $1,400 total, calculated as follows: $80,400 AGI - $75,000 threshold level = $5,400/$1,000 per increment = 5.4 increments above the threshold level but any fraction of an increment is rounded up making 6 increments in this case; 6 increments x 5% = 30%; $1,000 - (30% x $1,000) = $1,000 - $300 = $700 credit per child x 2 children = $1,400.

A child qualifies for the child tax credit if he or she meets all the following requirements:

For a more comprehensive definition of qualifying child, click on .

In cases where the child tax credit is refundable, it is labeled as (pdf file) and available to taxpayers with at least one qualifying child but without sufficient tax liability to extinguish the regular child tax credit. The refundable portion of the child tax credit is 15% of earned income (plus tax-free combat pay, if any) in excess of $11,750 reduced by the amount of regular child credit. Click on for instructions on how to calculate and claim the regular and additional child tax credits.

Example 2: Modifying Example 1 above, assume the single taxpayer doesn’t have sufficient tax liability to consume the regular child tax credit, say, a regular tax liability of $1,000 (but no AMT liability). He would be eligible for a refundable credit or additional child tax credit calculated as follows: (1) after reducing regular tax liability to zero, the taxpayer is left with a $400 child tax credit ($1,400 regular child tax credit - $1,000 tax liability); (2) comparing the 15%-of-earned income-over-$11,750 test amount or $10,298 ([$80,400 - $11,750] x 0.15) with $400 in step one and choosing the smaller, we discover the taxpayer is eligible for a refundable credit of $400 (remember our taxpayer is subject to phase out of the child tax credit since his AGI exceeds $75,000 thereby reducing the maximum credit per child from $1,000 to $700). Final tally for our single taxpayer: $1,000 regular child tax credit + $400 additional (refundable) child tax credit = $1,400. This example also illustrates the rule that any portion of the child tax credit that is phased out is lost and not recoverable by means of the additional child tax credit.

For taxpayers with three or more qualifying children, the additional child tax credit is the greater of (1) the result of the process outlined in Example 2 above for one or more qualifying children, that is, the smaller of the remaining child tax credit or 15% of earned income over $11,750 or (2) the excess of the taxpayer’s employee share of Social Security (FICA) taxes paid (including, if applicable, one-half of self-employed tax liability) over the , where this excess amount is limited to the child tax credit remaining after reducing regular and alternative tax liability to zero. In effect, the test for three or more children brings the difference between Social Security taxes paid and the earned income credit into the equation.

More information on the child tax credit is contained in the relevant articles listed below:

Many happy returns, Roger

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