What is the Earned Income Tax Credit (EITC)?

If you’ve ever filled taxes, at some point, you’ve probably heard of the earned income tax credit. Since this is a way to reduce your tax liability each year, many people wonder if they can claim the EITC on their next tax return.

But what is the Earned Income Tax Credit and how does the EITC work? More importantly, do you qualify for the EITC?

Thankfully, we’re here to help clear up all of your questions about the EITC. Coming up, we’ll walk you through the basics of what the EITC is and how you can file it on your next tax return. Let’s get started!

What is the Earned Income Tax Credit (EITC)?

According to the IRS, the EITC is “a benefit for working people with low to moderate income.” As a credit, the EITC is basically a dollar-for-dollar reduction of the overall amount of tax you owe.

For example, if you had an overall tax liability of $5000 and you claimed $1000 in credits, you would only owe $4000 in taxes. That’s pretty awesome.

On the other hand, deductions reduce your overall taxable income, or your AGI (adjusted gross income). So if you made $50,000 and had a deduction for $1000, your new taxable income (that’s used to figure the amount of taxes you owe) is now $49,000.

Thus, credits usually provide much more of a tax relief than a deduction does, which is why they’re so heavily sought after by hardworking people, such as yourself.

In fact, the Earned Income Tax Credit is a refundable tax credit, which means that if the EITC reduces your overall tax liability below zero, the IRS will pay you the difference, meaning you get money in your pocket come tax time. What’s not to like?

Who qualifies for the Earned Income Tax Credit?

Since everyone wants a tax credit (they’re just so awesome), there are some pretty strict rules in place to govern who can claim the earned income tax credit and how much they can use.

According to the IRS, to qualify for the earned income tax credit, you:

Must have earned income from working for someone or from running or owning a business or farm and meet basic rules. And, you must either meet additional rules for workers without a qualifying child or have a child that meets all the qualifying child rules for you.

IRS, 2019

It turns out that there are more rules written about who isn’t eligible for the earned income tax credit than about those who are. Here are some things to note if you’re wondering if you’re eligible for the EITC:

  • Social Security Number. Both you and your spouse, if married, and your qualifying children must have a social security number to claim the EITC.
  • Married Filing Separately. Anyone filing “married filing separately” is NOT allowed to claim the earned income tax credit. It’s really unclear as to why this is, perhaps to stop two individuals filing separately from both claiming the EITC for the same children, but this isn’t explicitly stated.
  • Investment Income. All of your investment income must be less than $3,600 for the year to meet the income requirements for the EITC and you must have at least $1 in earned income, which can’t come from pensions or unemployment.
  • Incarceration. You can’t count any income you received while working as an inmate to claim the EITC. Ineligible work includes any services you performed, regardless of their legality, while incarcerated, in a work release program, or in a halfway house.
  • Foreign Income. You can’t claim the earned income tax credit if you file Form 2555, which is for Foreign Earned Income or Form 2555-EX, the Foreign Earned Income Exclusion
  • Military and People with Disabilities. There are special rules for the EITC for military members, the clergy, and people with disabilities.

What are the income limits for the Earned Income Tax Credit?

It turns out that the income limits for the earned income tax credit are all based on how you file and how many children you claim. The IRS provides us with this table for 2019:

As you can see from the table, while a single individual with no children can claim the credit if they make less than $15,270, two married people filing jointly with three or more children can have a maximum income of $54,884. Thus, the more children you have the higher the income limit for claiming the earned income tax limit.

Keep in mind, however, that the incomes listed in this table are your Adjusted Gross Income, or AGI. So, you need to figure in all of your other deductions and expenses first before you calculate your AGI.

How much is the earned income tax credit?

Similar to the income limits for claiming the earned income tax credit, there is no one single maximum credit amount for the EITC. Instead, the IRS tells us that the maximum credit for the 2019 tax year is:

  • $6,557 with three or more qualifying children
  • $5,828 with two qualifying children
  • $2,526 with one qualifying child
  • $529 with no qualifying children

If you’re unsure of whether you have a qualifying child, you can check out the IRS’ rules here.

How much can I claim for the EITC?

The earned income tax credit is purposefully designed only to really benefit working families, which is why people with more children get a much larger tax break than people with no children (upward of $6,000 more in credits – that’s a lot).

That being said, your actual EITC for the tax year is pretty tricky to calculate as your credit is equal to a percentage of your total AGI, up to the point of your maximum credit. However, the credit rate varies by your family size with a larger credit rate awarded to families with more children.

The easiest way to figure out your EITC is to check out the IRS’s EITC Assistant, which will help you determine if you qualify for the credit and for what amount.

What happens if I make a mistake with my EITC?

As you can imagine, the IRS doesn’t take kindly to people who claim more of a tax credit than they’re eligible for. In fact, if you make an error when claiming your EITC, there are some serious consequences.

If you make a mistake with your EITC, the following can happen:

  • The EITC part of your refund can be delayed until the error is corrected. This can take a few months.
  • Your EITC can be fully or partially denied.
  • You may have to pay back the amount of EITC claimed in error, plus interest.
  • You may need to file Form 8862, Information to Claim Refundable Credits After Disallowance, to claim the EITC again.
  • If you intentionally or recklessly claimed the EITC with disregard for the rules, you could be banned from claiming it for the next two years.
  • If you claimed the EITC fraudulently, you can be banned from claiming it for the next ten years.

What is the Self Employment Tax?

Whether you’re new to freelancing or you’ve had a sole proprietorship for years, when you own your own business, you take on a whole new assortment of responsibilities when it comes to tax time. One of the most common questions we get from new freelancers is: What is the self employment tax?

The self employment tax (SE tax) is the fee that you pay to the federal government to cover the cost of social security and medicare when you’re self employed.

For many people, the self employment tax comes as a surprise, as it’s not something you’re used to paying when you work for someone else. Unfortunately, there’s also a lot of misinformation out there about taxes for freelancers, which is why we’re here to help clear the air.

Coming up, we’ve got your ultimate guide to the self employment tax, including information on what it is, how much you need to pay, and when you need to pay your self employment tax on your earnings. Let’s get to it!

What is the self employment tax?

As we’ve already discussed, the self employment tax is the amount that an individual pays to the federal government to cover their share of social security and medicare when they receive wages from self employment work. While this may seem like a “special tax” for freelancers, it turns out that employees pay it, too – it just happens to be withheld from their paychecks each month.

If you’ve ever received a pay stub from an employer, you’ll notice that there’s a deduction set aside for “FICA” taxes (Federal Insurance Contributions Act). These are the fees you pay toward social security (your federally sponsored retirement and disability insurance) and medicare (health insurance for older folks).

When you’re employed by a company, 6.2% of your paycheck is withheld for social security benefits while an additional 1.45% is withheld for medicare (as of 2019). As an employee, your federal income tax is also withheld from your paycheck, according to the withholding rates you calculate on your W-4. This happens automatically, with no extra leg work on your part when you work for someone else.

When you don’t receive regular paychecks from an employer where taxes are automatically withheld, however, you need to pay your own taxes directly to the IRS. This is where the self employment tax comes in the picture.

How much is the self employment tax?

The self employment tax rate, as with all tax rates, changes frequently. In 2019, the self employment tax rate is 15.3%. Does this sound like a lot? That’s because it is.

In fact, if you do the math, the self employment tax (the sole proprietor’s version of FICA) is exactly twice the amount that an employee pays for the same services. How does that compute?

Well, it turns out that when you’re employed, your employer has to pay half of your FICA taxes. This means that the actual FICA tax for individual employees is 15.3%, but your employer pays half of what you owe for you. You would never know this based on your pay stubs, which is why the self employment tax is such a surprise to new freelancers.

Who needs to pay the self employment tax?

At this point, you’re probably asking yourself: Do I need to pay the self employment tax? Here’s the IRS’s answer:

You must pay self-employment tax and file Schedule SE (Form 1040) if either of the following applies.
1. Your net earnings from self-employment (excluding church employee income) were $400 or more.
2. You had church employee income of $108.28 or more.

IRS.gov (2019)

Basically, if you’re not a church employee and you made more than $400 in self employment or freelancing income this year, you’re liable for self employment taxes. So, if you sold $399 worth of earrings on your Etsy shop, you’re off the hook. Otherwise, you need to pay up.

That being said, there are special rules for certain freelancers, especially people who work as family caregivers. You can learn more about those special rules here.

Do freelancers pay more in taxes than employees?

Now that you know how much more you need to pay in self employment tax as a freelancer, you might be wondering if freelancers pay more in taxes than regular employees. The unfortunate truth is that, yes, freelancers almost always pay more in taxes than employees.

Since freelancers need to pay both the additional self employment tax and their regular income tax based on their income level, they do, on average, end up paying more in tax than regular employees. Generally, most accountants recommend that freelancers plan to put aside upward of 40% of their income (even more if you’re a high earner or if you live somewhere with high state taxes) toward taxes each year.

When you compare this to a regular W-2 employee, this is quite a bit more. The main difference between a W-2 employee and self employed individual, however, is that the freelancer needs to pay that extra 7.65% toward the self employment tax that the W-2 employee gets paid for them.

What is the self employment tax deduction?

While it is true that freelancers pay more, on average, than a W-2 employee in taxes each year, there are quite a few tax breaks that freelancers can take advantage of, if they’re in the know.

Perhaps the most important tax deduction for freelancers, at least when it comes to the self employment tax, is the aptly named “Self employment tax deduction.”

What is this mysterious deduction, you might ask? Basically, it’s a way to deduct the amount of extra money you’ve had to pay in self employment taxes (when compared to a W-2 employee) from your overall income.

Basically, you can deduct half of what you paid in self employment tax for the year from your total adjusted gross income on your Form 1040. This means that if you made $100,000 this year from all of your income sources and paid $5,000 in self employment tax, you can adjust your total income to be $97,500 thanks to your new $2,500 deduction.

Since this is a deduction and not a credit, this tax break doesn’t directly decrease the amount you owe. Rather, it reduces your taxable income that’s used to figure the overall amount of federal income tax you need to pay.

Think of it as a small break for paying more than other folks, not a complete reparation for the extra money out of your wallet just for being entrepreneurial.

How do I pay the self-employment tax?

Unfortunately, many people begin their self employment career totally unaware of the self employment tax. As you can imagine, this comes as quite a shock to many new freelancers come tax time.

In fact, If you don’t pay your taxes during the year and you owe more than $1000 come tax time, you actually might get another fee slapped on top of the amount you owe. Ouch.

The solution? Don’t let this be you. Pay your self employment tax throughout the year as a part of your quarterly estimated taxes (more on this in another article).

How do you pay your self employment taxes? It’s actually quite easy, though there are a number of different ways to do it.

By far, the easiest way to pay your self employment and quarterly estimated taxes is through the government’s Electronic Federal Tax Payment System (EFTPS). This is a completely free service provided by the US Department of Treasury and it’s pretty simple to use.

To pay your taxes through the EFTPS, you’ll need to make an account. While making the account itself doesn’t take much time, you’ll need to receive a PIN in the mail, which takes a while. So, plan ahead and do this well ahead of the tax deadline for your quarterly schedule.

You can even connect your EFTPS account to your Quickbooks Self Employed account for any easy way to pay your estimated taxes. Since Quickbooks Self Employed estimates your tax payments for you, this is a super convenient, streamlined system for paying the feds on-time each quarter.

Another method for paying your self employment tax is to use the IRS Direct Pay system. Direct Pay allows you to pay your estimated taxes straight from your bank account.

Alternatively, you can use the IRS2Go Mobile App to pay your estimated taxes, check your tax refund status, or find free tax preparation assistance. This app works well on both Apple and Android devices, so it’s pretty handy. You will need to verify your identity before using it, though, so have your last two tax returns handy to get started.