The calculation of earned income is important for determining eligibility for the Earned Income Tax Credit. The EITC is a dollar-for-dollar reduction in your income taxes, or if you don't pay any income taxes, it is refundable to you when you file your tax return. You can also request advance payment of the EITC if you expect to receive a refund at the end of the year. Your paychecks throughout the year will be increased with a portion of the EITC that you expect to receive when you file your annual tax return.
Tax Credit Versus Tax Deduction
A tax credit is different from, and worth more than, a tax deduction. A tax deduction reduces your taxable income, while a tax credit is a dollar-for-dollar reduction in taxes owed. For example, say you earned $56,000 during the year, and you have $6,000 in tax deductions. Your taxable income is $50,000. If your tax rate is 10%, you will owe $5,000 in income taxes. However, if you qualify for a tax credit of, say, $2,000, the tax you owe is reduced dollar for dollar in the amount of the credit, so you only owe $3000. So in this example, the $6,000 tax deduction actually only saves $600 in taxes, while the $2,000 tax credit saves $2,000.
Nonrefundable Tax Credits
Some tax credits are refundable, and some are not. When a credit is not refundable, that means you can only use the credit up to the amount of your total taxes due, but no more than that. So, assume you owe $2,000 in taxes but you qualify for a $3,000 nonrefundable tax credit. Your tax liability is reduced by $3,000, which means you owe zero taxes. Since the tax credit is not refundable, you pay no taxes, and you receive no money either. The extra $1,000 in tax credit ($2,000 tax due minus the $3,000 tax credit) simply disappears.
Refundable Tax Credits
When a tax credit is refundable, that means you can receive the full amount of the credit as a "refund" even if you don't pay any taxes. Using the same example from the previous section, assume you owe $2,000 in tax, but you have a refundable $3,000 tax credit. Since the credit is refundable, you will pay zero taxes, and in addition, you will receive a $1,000 check from the IRS. You receive the $1,000 "refund" even though you paid no taxes for the year. So a refundable tax credit is a good thing.
Earned Income Credit
The Earned Income Credit is one of the most valuable tax credits because it is fully refundable. So even if you don't make enough money to pay a single dollar in taxes, you still might receive more than $5,000 in a tax refund check from the IRS when you file your tax return. The exact amount of the credit depends on the amount of money you earned during the year, how many children you have and several other factors.
Advance Payment of the Earned Income Credit
If you know you will qualify for the EITC, you can receive the money in two different ways. First, you can wait until the end of the year when you file your tax return, and you will receive a check for the full amount of your tax credit at that time. Alternately, you can request advance payment of the EITC, which means you will receive a portion of the credit with each paycheck you earn throughout the year. That way, you can get the money each time you are paid, instead of waiting until the year's end.
Calculating the Earned Income Tax Credit
Whether you request your Earned Income Tax Credit in full at the end of the year or in installments with each paycheck during the year, you need to calculate your annual EITC. The details of this calculation are complex, but the IRS provides an online estimator (see Resources). Be sure you enter the correct tax year.