Earned Income Tax Credit

The earned income tax credit is a refundable tax credit for low- to moderate-income working taxpayers to raise their incomes without discouraging work. The federal government offers the earned income tax credit, or EITC, for all taxpayers, though it should be noted that 22 states also offer an additional refundable EITC.

The amount of the EITC depends on the taxpayer's income and number of child dependents. Let's go over the difference between tax credits and tax deductions, refundable and unrefundable tax credits, how the earned income tax credit is calculated, and who is eligible for the credit.

Earned income tax credit
The earned income tax credit was first enacted in 1975 under the Ford administration in an effort to address poverty in the U.S. The EITC has been updated multiple times, becoming indexed to inflation in 1986, and getting a large boost in 1993. The EITC is now the third-largest anti-poverty program in the U.S behind food stamps and Medicaid grants.

The EITC phases in as a person's income grows and then slowly phases out as a person reaches a moderate income. The idea is to support those with low incomes while incentivizing people to work and earn income.

Tax credits versus tax deductions
A tax credit allows you to directly subtract the amount of the credit from your taxes due. On the other hand, tax deductions typically allow you to subtract the amount of the deduction from your taxable income.

Let's look at an example. Say you are single and had $40,000 in income, based on the 2014 tax brackets, the standard deduction, and one personal exemption, you would owe a little over $4,000 in taxes. A $5,000 tax credit would cancel out all your taxes owed. On the other hand, a $5,000 tax deduction would drop your taxable income to $35,000, ultimately reducing your taxes owed by a smaller amount. So, given the numbers above, you would still owe $3,300 in taxes after a $5,000 tax deduction.

Refundable credit versus unrefundable tax credit
There are two types of tax credits: refundable tax credits and unrefundable tax credits. You can get money back for a refundable tax credit even if you didn't earn any income or pay any taxes. An unrefundable tax credit only allows you to get a refund for the amount of taxes paid.

Let's say you owe $1,000 in taxes from income during the year, and at the end of the year, you claimed a $2,500 tax credit. If the tax credit is refundable, you'll get $1,500 back from the government. If the tax credit is unrefundable, then it is deducted from the taxes you owe -- so in this example, you don't owe the government anything, but you can only zero out your taxes, meaning you miss out on the remaining $1,500 of the tax credit.

Earned income tax credit for 2014
There are a few key points to note about who is eligible for the EITC. First, you must be older than 25 but younger than 65 in order to claim the credit. Second, you cannot be claimed as a dependent of another person. Third, if your investment income is greater than $3,350 in 2014, you are completely ineligible for the EITC.

There are then two key factors for the earned income tax credit:

  1. Your level of earned income
  2. The number of children you claim as dependents

The earned income tax credit phases in as a percentage of income until it hits a plateau, beyond which it phases out. The income limit is low, but it rises with the number of children you can claim. The IRS provides an FAQ on who is a qualifying child.

EITC Income Limits for 2014 

Number of Qualifying Children

Single/Head of Household

Married Filing Jointly

0

$14,590

$20,020

1

$38,511

$43,941

2

$43,756

$49,186

3 or more

$46,997

$52,427

Source: IRS.

So how much of a credit can you get?

EITC tax year 2014 maximum credit:

  • $6,143 with three or more qualifying children
  • $5,460 with two qualifying children
  • $3,305 with one qualifying child
  • $496 with no qualifying children

The IRS provides an online EITC Assistant to determine whether you are eligible and estimate how much you can earn.

In the case of the EITC, it is not always in your interest to have unearned income, as you may lose the tax credit if your unearned income is greater than $3,350 in 2014. However, the EITC is structured so that it is always in your interest to earn more income.

Dan Dzombak can be found on Twitter @DanDzombak, on his Facebook page DanDzombak, or on his blog where he writes about investing, happiness, the secret to success in life, what is success to you, the NY Lottery, and the Fortune 500. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.