The Earned Income Credit (EIC) was enacted in 1975 to provide economic assistance to working families, particularly those with children. It has expanded over the years with over 16 million American families currently benefiting from the credit. Recent Census data show that the EIC lifts more children out of poverty than any other government program. It has become particularly important in the South, where wages tend to be lower.
The idea behind the credit is to incentivize low-income parents to enter the workforce by increasing with income; to a point thereafter, the credit decreases and eventually phases out. The credit also increases depending on the number of children residing in the household with a "child" being defined as anyone up to 18 years old or between 19 and 23 if in school at least half-time.
The following chart demonstrates how much credit a taxpayer can expect. The amounts shown are for unmarried taxpayers. The maximum credits for married taxpayers are the same, but the income phaseouts are about 10% higher.
A few restrictions have been put on the EIC to help make it more effective. Anyone claiming the credit must:
Have “earned income” (as the name implies.)
Be between 25 and 64 years old on the last day of the year or have a qualifying child.
Have less than $11,000 per year of investment income.
Be a US citizen with a valid Social Security Number residing within the United States for more than half of the year. (Exceptions apply for military service.)
One common misconception is that a child must be claimed as a dependent to qualify for EIC which is NOT true. We often see this with divorced parents who claim a child every other year. Even though the dependency “bounces” in accordance with the divorce decree, the EIC always remains with the custodial parent. I hear a lot of single moms’ lament that they can’t get the EIC because it’s not their year but that is not the case. EIC always stays with the custodial parent!!!
There are also tax credits for claiming a child as a "dependent" but those are separate and in addition to the EIC. These credits are partially refundable, unlike the EIC which is one of the few fully refundable credits meaning that it can be received in full even if no other tax liability exists.
Self-Employment and MAGI
For anyone running a small business, the EIC is especially useful because it can be used to offset the Self-Employment Tax aka FICA Tax. (This 15.3% tax is indicated on the chart above as a straight line.) When a self-employed person claims the EIC, their refund (or amount they owe) is the difference between the EIC and the S/E tax.
It's also worth noting that EIC is not based on Adjusted Gross Income (AGI) but rather Modified Adjusted Income (MAGI) meaning that the credit is figured using just earned income and then re-calculated using total income and taking the smaller of the two credits. This means that adjustments such as contributions to an IRA have no effect on the EIC.
Business deductions such as accelerated depreciation however DO affect the EIC, which is why careful consideration needs to be given to the timing of small business income and expenses. At The Tax Company, we always try to calculate the optimal use of business deductions to maximize the credit for not just the current year, but future years as well.
With such a generous credit, there is bound to be fraud and the IRS takes a hard line against abusing the EIC. Anyone caught is given a 10-year ban on claiming the credit. There are exceptions for honest mistakes but it’s something that should be avoided if possible. The most common thing the IRS asks for when auditing EIC claims is proof of residency of the qualifying child. This can include things like medical records, school records or any other third-party evidence showing that the child’s address matches that of the parent. These are not the typical things you think of to get you through an IRS audit, which is why retaining a qualified tax professional to handle your EIC claim is always advisable.
From its modest beginnings to its enhancement in the 80’s and 90’s, the EIC stands as a vital tool in the fight against poverty and a testament to the power of bipartisan collaboration. It is also a powerful tool in our never-ending fight to keep your taxes as low as possible.