The Internal Revenue Service and Congress want to motivate lower-income taxpayers to earn a greater amount of income. There's not unearned income tax credit. However, there's an earned income tax credit that's meant to provide just such an incentive. This tax credit is applicable only to individuals that earn income under a certain amount each year and is essentially the government paying the taxpayer, rather than them paying taxes to the government.
Earned Income Credit
The earned income credit is a provision of the government that's similar to a reverse income tax, as the money is paid to the taxpayer. To qualify, you must earn income during the tax year, and it can't exceed the limits set forth by the IRS for the applicable year. The earned income credit doesn't necessarily mean that you'll receive a refund for the tax year in which you claim the credit. A credit simply reduces your tax liability, or what you owe the IRS. However, it's a refundable credit, so if the amount you qualify for exceeds your tax liability, you receive a refund.
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Limits and Qualifications
To qualify for the earned income credit, aside from having earned income from a job, you must be a U.S. citizen, not have investment income greater than $3,100, not have foreign earned income, have a valid Social Security number and not file with the status "Married, Filing Separately." You must also have an adjusted gross income — found on Line 37 of Form 1040 — that doesn't exceed a certain amount for each filing status. The limits as of 2010 were $13,460 for single or head of household and $18,470 for married filing jointly and no qualifying children; $35,535 for single or head of household and $40,545 for married filing jointly and one qualifying child; $40,363 for single or head of household and $45,373 for married filing jointly and two qualifying children; and $43,352 for single or head of household and $48,362 for married filing jointly and three or more qualifying children.
The limits differ for taxpayers with one or more qualifying children. A qualifying child is one who meets the relationship, age and residency tests as set forth by the IRS. To meet the relationship test, the child must be your son, daughter, stepchild, foster child, brother, sister, stepbrother, stepsister, half brother, half sister or descendant of one of these. The child must be under the age of 19 as of December 31 of the current tax year, or under the age of 24 and a full-time student, or permanently and totally disabled. To meet the residency test, the child must have lived with you for more than six months of the tax year.
Figuring the Earned Income Credit
Generally, the IRS computes the earned income credit for you, as there's a phaseout that begins at the income limits stated previously. However, you can compute the earned income credit for yourself. First begin with the amount that appears on Line 7 of Form 1040 or Form 1040A, or Line 1 of Form 1040EZ. Reduce that amount by any money you received for a scholarship or grant not reported to you on Form W-2; income received while you or your spouse was an inmate; a pension or annuity from a nonqualified or governmental deferred compensation plan; money for services as a member of the clergy or church employee; and any amount received for noncombat pay.
You don't qualify for the earned income credit under certain circumstances, such as if you're under the age of 25 or the dependent or qualifying child of another taxpayer. Another reason for which the IRS disallows you to claim the earned income credit is if you're over the age of 65. If you claim your child as a qualifying child, then no one else can claim him.