A. Earned Income Credit
The Earned Income Tax Credit (EITC) Can be used for the basis of building wealth:
Here is how it works;
If you have at lease one child that lives with you over half the year, you may be eligible for this credit. It is set up so that the more money you earn, the higher the credit until you reach an income of $8,050 for one child or $11,300 for two or more children. The credit peeks at $2,747 for one child and $4,536 for two or more children. Therefore the credit can increase your income by 34% to 40%.
The credit then levels off then decreases as income increases but don't stop striving to increase your earned income. Other credits come into play that I will show you latter that will help make up for the reduction in the earned income credit.
In this first example we can see how much a family of four may benefit from the. (EITC)
Income $16,000
Tax 0
Earned income credit 4,280
Total income $20,280
The (EITC) increases family income by $4,280 or about 25%
This lump-sum payment can become the basis for building wealth. Here are a few suggestions:
1. This lump sum can go a long way toward closing costs on a home purchase.
2. The IRS will allow you to receive up to half the credit along with your normal paycheck, when you complete a form W5. In this way the tax system helps you with the house payments.
3. The payment can be contributed toward a Roth IRA that can grow tax free for future needs.
Sometimes we need the funds to take care of everyday needs, but I would still encourage you to save as much as you can. In this way you can still start building wealth.
B. Child Tax Credit
As your income increases The Child Tax Credit provides additional help for working families. Let's see how this works:
The child tax credit is divided into two parts:
1. The first part provides $1,000 per child under the age of 17 to reduce the federal income tax.
2. The second part is a refundable portion that is designed to provide additional cash for families as the (EITC) decreases.
Let's take another look at the family of four in the first example and see how the child tax credit may increase the total available cash as income increases:
Income $16,000
Tax 0
EITC 4,280
Additional child tax credit 705
Total income $20,985
There are those out there that limit the amount that they work because they want to maximize the earned income credit. But as you can see in the example above as income increases and EITC decreases the additional child tax credit increases.
If the couple above stopped working when they had earned $11,300 so they could receive the maximum EITC of $4,536 their total income would have been $15,836. By continuing to earn income their total credits increased by $449 and they received a total of $5,149 additional income.
In the next example a family of four can increase their earnings by over 50% and still receive more than $4,000 in refundable credits after federal income tax.
The family earned $25,000 a year. The spouses filed married filing joint with two children under the age of 17 that live with both parents all year. The total income should look like this:
Income from wages $25,000
Earned income credit 2,385
Additional child tax credit 1,850
Total income $29,235
The total credits were reduced by a few hundred dollars but the total family income increased by $8,250.
Now let's look at an example where the family's income has doubled again: The married couple makes $50,000 a year, have two children under the age of 17. This family took my advice, purchased a home, sold it and moved up to a larger home, let us take a look at their income. They pay $10,000 a year in interest, $2,000 in real estate tax, $1,000 in state tax and have $5,000 in contributions.
Income from wages $50,000
Less contributions to IRA 5,000
AGI $45,000
Taxable income $13,800
Tax 0
Refundable credit 620
This family of four is now making over three times what they were making even with the earned income credit and they are still receiving a refundable credit. If they took the standard deduction of $10,300 instead of itemizing $18,000 their federal tax would be $474. They would still receive a benefit of a $2,000 tax reduction from this credit.
C. Children's Exemption
Now let's take the examples above and see more tax savings from using the child's exemption:
In the first example the children's exemption didn't provide any tax reduction but the earned income credit and child tax credit provided $4,985 to the family's income amounting to 34% of the family's total income.
The second example each child provided $405 in tax savings in addition to the EITC and child tax credit, their total contribution to the family income is $5,045 or 17% of total income.
The third example the children provide $461.5 in tax savings each in tax plus the additional benefit of the child tax credit of $1,000 each. This represents a total tax savings of $2,923. In this example the children only contribute about 6.5% of the family income. In the next section we will take a look at another benefit that is provided in the tax code the standard deduction.
D. The Child's standard deduction
Each child can earn up to the amount of their standard deduction without affecting the credits or having a federal tax liability.
In the last example the parents are self employed. The self employed pay double social security and Medicare tax and this tax is called self employment tax. On page 8 of IRS publication 15 (Circular E) under "Family Employees" it states that "Payments for the services of a child under age 18 who work for his parent in a trade or business are not subject to social security and Medicare taxes if the trade or business is a proprietorship or partnership where each partner is a parents of the child."
The IRS doesn't let you charge for food or rent to your minor child but think of the possibilities. You no longer need to set a college fund, date fund, car fund, in some cultures a mission fund. All of these expenses can come from the child's own funds. In the following two examples let's see how much you may save on just self employment tax. In this example $8,000 of deductible health insurance premium and HSA contribution has been figured in the calculation.
We will consider two examples the first we will see what tax is without the child working then in the second example we will how much is save by having the child work.
Income from self employment $75,000
Self employment tax 9,466
Federal income tax 3,967
State income tax 1,863
Child tax credit 2,000
Income after tax $61,703
In this example the children where worth $3,416, ($2000 child tax credit, $956 federal tax and $460 state tax) now let's look at the other example where the children work for their parents and earn the amount of their standard deductions.
Income from Self employment $64,700
Self employment tax 8,011
Tax 2,466
State tax 1,209
Child tax credit 2,000
Sub-total $55,014
Child's income 10,300
Total $65,323
In the second example the children contributed and additional $3,620, ($1,455 savings from self employment, $1501 federal tax, and $654 state tax). They contributed a total of $7,036 to the family. Another way to look at this is it only cost $3,264 for two employees; likely this is less than the allowances and expenses you would have if they weren't working.
