How to Maximize the Child Tax Credit and EITC
Today’s question comes from a lovely reddit user who asked how she could get the maximum value from the Child Tax Credit and Earned Income Tax Credit. It's an interesting case study and a great opportunity to showcase how to create a tax plan and a tax budget.
Hopefully, her results will inspire you to create your own tax plan to maximize your income tax credits and deductions.
What is the best way to file to maximize our Tax Credits?
Reader: Would getting married hurt or help our taxes, and what is the best way to maximize our Child Tax Credit.
That is a great question and is one that is on a lot of people's minds right now since the Child Tax Credit is partially refundable. Taxes can be complicated and the tax code is full of exceptions, exclusions and extenuating circumstances that could impact your decisions or eligibility for certain programs.
Keep in mind, before making any life-changing decisions you should consult with a professional who will have the benefit of being able to thoroughly review your situation.
In this post, we will discuss how to estimate your income taxes with the available free resources. It is important to create a tax plan as part of your budget during the tax year because your tax planning options are limited after Dec. 31st.
What we know
Our Reader provided some background information, here is what we know.
- She and her partner are unmarried and have 1 Dependent Child.
- She makes $6,000 a year
- He makes approximately $34,000 a year
- He contributes 8% to an employer-sponsored 401K
Since we do not have access to the readers previous years tax returns and supporting information for illustration purposes we will need to make certain assumptions.
- We will assume all wages are reported on a W2
- We will assume that the couple has no other sources of taxable income such as interest, dividends or capital gains.
- That the couple did not take a distribution from a taxable retirement account or annuity.
Caution; This case study is to be used for illustration purposes only, and should not be relied on for tax, legal or investment advice. Before engaging in any tax planning consult a properly licensed professional.
How To Create a Tax Plan
Step 1. Gather Your Documents
To create a tax plan, you will need to gather your tax documents to accurately forecast your taxable income. The documents you will need;
- Recent pay stub(s)
- Last year’s tax return
- Profit and loss statements for any businesses you own
- Current bank and investment statements detailing year-to-date, gains, interest, and dividends.
- Cost basis and sales price of any items you have sold
- A breakdown of any other sources of taxable income
- A print out of the requirements for any tax programs you hope to use
Step 2. Calculate your baseline
Before you jump into the exciting world of tax planning, it's important to calculate your starting point. Having a baseline estimate will help you determine if tax planning makes sense. A baseline will also give you an estimate of how much you could expect to benefit.
A baseline is simply an estimate of your taxes before doing any tax planning.
Tip: In the past we could use a prior year’s tax return as a baseline if you expected your income and deductions to be about the same. However, the recent tax bill significantly changed many aspects of the tax code and its best calculate a new baseline.
To calculate out a baseline, it will be helpful to use the software. If you do not have access to commercially available tax software, you can calculate your estimates by hand or use some free online calculators. I did a google search, tried a few different offerings, and narrowed it down to two options.
The IRS has a calculator designed to estimate how much you should have withheld in taxes if you a have some familiarity with taxes you could use it to estimate your taxes owed or anticipated refund.
Pros, The IRS calculator estimates your Earned Income Tax Credit, and because it’s an official IRS calculator the site is ad and spam free.
Cons, the website is kind of clunky, loads slow, and you need to know the amount of other credits you may qualify for.
Resource: List of tax credits.
Alternatively, eFile.com offers a free 2018 income tax estimator. I have no affiliation with eFile.com. Most tax preparation companies offer a calculator. I briefly tested the most popular ones and liked the one on efile.com the best.
Pros, the site loads fast which is great for running multiple scenarios, and is simple to use
Cons, the calculator does not calculate the value of tax credits you may be eligible for.
Caution: I have no experience with eFile.com outside of my initial review of their calculator. I cannot speak to how they would compare to other tax preparation sites for tax preparation. Remember to always do your homework.
You will need a way to estimate your Earned Income Tax Credit if you are eligible, there is a handy calculator here. (It does not appear to be updated for 2018 yet, however, the figures are close)
The IRS has a more extensive EITC assistant that will help you determine eligibility and estimate the amount of the credit.
You can also calculate out and estimate your taxes by hand using the IRS tax tables and the 2018 estimated tax worksheet.
Estimate Your Income
To use the calculator, you will need to estimate your earnings for the year and your tax withholdings. If you receive a paycheck you can multiply your current paycheck by the number of pay periods in the year to estimate your annual earnings.
Make sure you use your gross pay and not your “take-home pay”. Should you have any non-deductible payments to insurances, state and local taxes they could throw off your estimates.
When calculating your baseline, write down the following information:
- Your estimated Adjusted Gross Income (AGI)
- The amount of taxes you had withheld
- The amount of each tax credit you qualified for
- How much you are anticipated to have refunded or owed in income taxes.
You will need all these figures to compare with any potential tax planning.
Step 3. Tax planning
Now that you are armed with your baseline statistics its time to check for potential tax saving opportunities.
Check to see if you are receiving all your withholdings back. If you are not receiving all your withholdings back, then there is potential for you to save money in taxes.
Next item to check is to see if you potentially qualify for any refundable tax credits. Refundable tax credits are the most desirable tax credit because the government could pay you in excess of what you had tax withholdings. Refundable tax credits are essentially “free” money from the government and are a great tax planning opportunity.
Tip: Remember if you buy health insurance on the Marketplace reducing taxable income may make your health insurance more affordable.
Compare your anticipated income with the income requirements for any program you would like to use.
Example: if you just miss qualifying for the Retirement Saver Credit then there may be an opportunity to lower your AGI to qualify.
Compare the amount of your anticipated baseline credits with the maximum credit allowed.
Example: if the maximum refundable Child Tax Credit allowed is $1400 (per child), however, if you only receiving $800 back then there may be an opportunity for planning. Some of your credit may be going to pay incomes taxes that could be reduced with other measures.
After you have uncovered the potential opportunities to save money in taxes you will then need to go back to the calculators and estimate various changes. This part can get a bit tedious as you may need to run various scenarios to find the best solution.
Once you run through a few options you should get a sense of how the various programs interact with each other.
Tip: Make sure with each scenario you write down all the figures, so you can compare the various planning options.
The ideal situation is to zero out your tax bill with various deductions and have the full value of any refundable tax credits paid to you. However, it may not be in the budget to get your taxable income that low. Additionally, you may be in such a low tax bracket it’s not worth going to heroic measures to save money in taxes.
Using a tax plan to solve our reader's questions.
One concern our reader had was if she and partner got married, would it impact her partner's ability to claim the Earned Income Tax Credit. We can use the calculator at eitcoutreach.org and estimate the two scenarios.
Situation 1. The partner files Head of Household with $33,120 of income (Remember 8% is going into a 401k)
Situation 2. Our reader and partner file Married Filing Jointly with $37,120 of income
Based on this circumstance, Married Filing Jointly offers a slightly higher EITC.
Additionally, filling as Married Filling Jointly you will have a larger standard deduction as well as a larger retirement savers credit. Not knowing the amount of your tax withholdings, I cannot estimate the amount of your anticipated refund.
However, using the efile.com calculator you can compare the two filing scenarios and assume no taxes were withheld to get an estimate.
Using the above two situations we get the following results:
Situation 1. The partner files Head of household with $33,120 of income (no withholdings)
Situation 2. Our reader and partner file Married Filing Jointly with $37,120 of income
Using the above scenarios and assumptions, Married Filling Jointly beats out the alternative. Keep in mind individual results may vary.
However, based on the assumptions used here, there is approximately a $1300 difference between the two filling options. For families looking to save some extra money, pay down debt, or would like some extra breathing room in the budget, tax planning can pay big “dividends.”
I would like to thank our reader for posting a great question and interesting case study.
If you have a question you would like considered for a financial feature please feel free to submit it here.