ARPA Liberalizes the Earned Income Tax Credit Rules

The earned income tax credit (EITC) has been around for years. But for some folks, it’s never been worth as much as it will be for 2021.

That’s thanks to liberalization included in the new American Rescue Plan Act (ARPA). Some of the favorable changes are only for the 2021 tax year. Others are permanent.

Here’s what you need to know, starting with some necessary background information.

EITC Basics

The EITC is targeted at low-income and moderate-income individual taxpayers. Perhaps, most important, it’s a refundable credit.

That means you can collect it even if you don’t owe any federal income tax. In other words, it’s free money.

If you’re an eligible individual, your tentative EITC (the maximum you can hope for) equals the applicable credit percentage of your earned income for the year.

The tentative EITC is then reduced by the phaseout amount, if applicable, to arrive at your allowable EITC.

Eligible Individual Defined

In general, you are an eligible individual if you have at least one qualifying child for the tax year in question.

If you don’t have a qualifying child, your principal residence must be in the U.S. for more than half the year and you must meet the age requirement (explained later). You cannot be an eligible individual if you can be claimed as a dependent of another taxpayer or if you are the qualifying child of another taxpayer.

In general, you cannot be an eligible individual if you are a non-resident alien. Finally, your Form 1040 must include your taxpayer identification number (usually your Social Security number) and your spouse’s taxpayer identification number if married.

Earned Income Defined

The term earned income generally means

  • wages, salaries, tips, and other taxable employee compensation, and
  • any net earnings from self-employment reduced by the deduction for 50 percent of self-employment tax.
Qualifying Child Defined

The term qualifying child means your child; a descendant of your child (such as a grandchild); or your brother, sister, stepbrother, or stepsister (or a descendant of one of those persons).

To be your qualifying child, the individual must also have the same principal residence as you for more than half of the year in question. The individual must be younger than you and

  • under age 19 at the end of the year, or
  • a student who is under age 24 at the end of the year, or
  • permanently and totally disabled at any time during the year.

Finally, the individual cannot have filed a joint Form 1040 for the year.

EITC Calculation in a Nutshell

Under the rules that apply for your 2020 Form 1040, tentative EITC equals

  • 7.65 percent of the first $7,030 of earned income if you don’t have a qualifying child,
  • 34 percent of the first $10,540 of earned income for one qualifying child,
  • 40 percent of the first $14,800 of earned income for two qualifying children, or
  • 45 percent of the first $14,800 of earned income for three or more qualifying children.

The phaseout rule applied only if your adjusted gross income (AGI), or your earned income (if greater than AGI), exceeds the applicable phaseout threshold. For 2020, the maximum tentative credit, phaseout percentages, and phaseout ranges (based on AGI or earned income, whichever is greater) are as follows.

Phaseout Range
Tentative Credit Phaseout Percent Not a Joint Filer Joint Filer
No Children  $        538 7.65% $8790 – $15,820 $14,680 – $21,710
One Child  $    3,584 15.98% $19,330- $41,756 $25,220- $47,646
Two Children  $    5,920 21.06% $19,330- $47,440 $25,220- $53,330
More Children  $    6,660 21.06% $19,330- $50,954 $25,220- $56,844

For instance, for 2020, the tentative EITC is $3,584 for a married joint-filing couple with one qualifying child and AGI of $27,000. The phaseout rule reduces the allowable credit by $284: 15.98 percent X ($27,000 – $25,220) = $284. So, the allowable credit is $3,300 ($3,584 – $284).

If the couple’s AGI exceeds $47,646, their EITC is completely phased out. Use the table in the Form 1040 instructions to find the exact allowable EITC amounts.

For 2021, the inflation-adjusted earned income amounts are $7,100; $10,640; $14,950; and $14,950, respectively. For 2021, all the other numbers in the preceding table are also adjusted slightly upward for inflation. For instance, the tentative EITC for 2021 is $6,728 if you have three or more qualifying children and are unaffected by the phaseout rule.

Finally, if you have uncertain types of investment income over the applicable annual inflation-adjusted threshold, you’re completely ineligible for the EITC. For 2020, the investment income cap was $3,650. It was scheduled to be the same for 2021, but the ARPA increased the cap, as explained later.

Under the “regular” EITC rules before the ARPA changes, an individual with no qualifying children had to be at least age 25 but no older than age 64 as of the end of the year in question. Under those rules, if you’re 24 or younger or 65 or older, you’re out of luck.

Temporary Changes (for 2021 Only)

For 2021 only, the ARPA makes the following taxpayer-friendly changes to the EITC rules.

Enjoy More Favorable Rules If You Have No Qualifying Children

The age restriction if you have no qualifying children is significantly liberalized. For 2021, you generally must be at  least age 19 as of December 31, 2021 (versus age 25 under the regular rules), and there’s no upper age limit (versus an upper limit of age 64 under the regular rules).

If you are a specified student (as defined), the minimum age is 24 for 2021.

If you are a qualified former foster youth or a qualified homeless youth (as defined), the minimum age is 18 for 2021.

Under the regular rules, the tentative EITC for 2021 if you have no qualifying children was scheduled to be only $543. Thanks to the ARPA, the tentative EITC for 2021 is upped to $1,502.

That increase is because the credit percentage is doubled to 15.3 percent and the earned income base is increased to $9,820.

Finally, the phaseout threshold (based on your AGI or earned income, whichever is greater) is increased to $11,610 of AGI, so fewer individuals with no qualifying children will see their EITC reduced by the phaseout rule.

Calculate 2021 EITC Using Either Your 2019 or 2021 Earned Income (Whichever Offers the Bigger Credit)

To calculate your EITC for 2021, you can use either your 2019 earned income or your 2021 earned income. Use the number whichever gives you the bigger 2021 credit.

If you choose to use the 2019 number, it won’t have any effect on any of your other 2021 federal income tax calculations. For instance, say some or all of your earned income is from self-employment. Choosing to use your 2019 earned income to calculate your 2021 EITC won’t increase your 2021 self-employment tax bill.

Key point. For 2021, your tentative EITC – that is, the maximum you can hope for – can range from $1,502 (if you have no qualifying children and are unaffected by the phaseout rule) to $6,728 (if you have three or more qualifying children and are affected by the phaseout rule).

Permanent Changes (for 2021 and Beyond)

For 2021 and beyond, the ARPA makes the following permanent taxpayer-friendly changes.

Be Eligible with More Investment Income

Under the pre-ARPA EITC rules, you would have been ineligible for the EITC in 2021 if you had more than $3,650 of disqualified income (basically, certain types of investment income as explained below). Thanks to the ARPA, you can have up to $10,000 of disqualified income without losing out on the EITC for 2021. For 2022 and later years, the $10,000 limit will be adjusted for inflation.

The term disqualified income means taxable interest and dividends, tax-exempt interest, net income from most rents and royalties, net capital gain, and net income from passive activities.

Benefit from the Liberalized Rule for Married Individuals Who Are Separated

If you’re married, the general rule is that you must file a joint Form 1040 to claim the EITC.

But if you’re separated from your spouse, filing a joint Form 1040 may be a bad idea. That’s because filing jointly generally makes you jointly and severally liable for your spouse’s federal income tax misdeeds. Then the IRS can come after you to collect, even after you’ve divorced. Not good!

For that reason, pre-ARPA law granted an exception that allowed eligible separated spouses to file separate returns using married-filing-separate status, or head-of-household status when allowed, and still claim the EITC.

Filing a separate return isulates you from your spouse’s federal income tax foibles. To be eligible for this prior-law relief, a separated spouse had to meet certain requirements – including living with a qualifying child and not living with the spouse during the last six months of the year.

For 2021 and beyond, the ARPA includes a permanent change that will allow more married-but-separated individuals to claim the EITC without having to file a joint Form 1040. The new general rule says you can claim the EITC on a married-filing-separately  return or on a head-of-household return (when head-of-household filing status is permitted), as long as a qualifying child lives with you for more than six month during the year in question and you either

  • do not have same principal residence as your spouse for the last six month of the year, or
  • have a separate instrument in effect (a court decree or agreement other than an actual divorce decree) and do not live in the same household with your spouse as of the end of the year.

Claim the EITC Even If You Don’t Meet Child ID Requirements

Under the pre-ARPA rules, you cannot claim the EITC based on a qualifying child unless you include the child’s name, age, and taxpayer identification number (generally a Social Security number). Failure to provide child ID information also made you ineligible to claim the EITC under the rules for someone with no qualifying children. In other words, you were flat out of luck.

But for 2021 and beyond, the ARPA permanently removes that rule. So, if you fail to provide child ID information, you can claim the EITC under the rules for someone with no qualifying children. Fair enough.

Takeaways

The ARPA made favorable changes to the EITC rules. Some are temporary, for 2021 only. Others are permanent, for 2021 and beyond.

The most important changes are (for 2021 only) the liberalized rules for taxpayers with no qualifying children and (for 2021 and beyond) the permanent increase in the amount of investment income that you can have without becoming ineligible for the EITC.

While your income may be way too high to claim for the EITC, you may have loved ones who are eligible. According to a report by a Treasury Inspector General for Tax Administration, about five million potentially eligible taxpayers fail to claim the EITC each year, resulting in about $7 billion unclaimed credits each year. Don’t let a loved one fall into this category.

There’s no IRS for dedicated to the EITC. You must use the worksheets provided in the Form 1040 instructions to calculate your allowable credit. Pack a lunch – it takes a while!

 

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