What Is Disqualifying Income?

Disqualifying income is a type of income that can prevent an otherwise eligible low- or moderate-income taxpayer from receiving the earned income credit (EIC) when filing their annual income taxes. To determine whether a taxpayer's income level qualifies for the EIC, they should consult IRS Publication 596. If a taxpayer’s income qualifies to claim the EIC on a federal income tax return, they may also be eligible to take a similar credit on their state and local returns.

Key Takeaways

  • Disqualifying income is a type of income that can prevent an otherwise eligible low- or moderate-income taxpayer from receiving the earned income credit (EIC) when filing their annual income taxes.
  • Disqualifying income consists of investment income, such as taxable and tax-exempt interest, dividends, pensions and annuities, net income from rents and royalties, net capital gains, and net passive income (not received as a result of self-employment).
  • For the tax year 2020, income derived from investments cannot exceed $3,650.

Understanding Disqualifying Income

Disqualifying income consists of investment income, such as taxable and tax-exempt interest, dividends, pensions and annuities, net income from rents and royalties, net capital gains, and net passive income (not received as a result of self-employment).

The American Rescue Plan, signed by President Biden on March 11, 2021, made changes to the Earned Income Credit for 2021. For 2021 only, the size of the earned-income tax credit will increase for childless households. The maximum credit amount for childless people increases to $1,502, from $543. The age range has also been expanded. People without children will be able to claim the credit beginning at age 19, instead of 25, with the exception of certain full-time students (students between 19 and 24 with at least half a full-time course load are ineligible). The upper age limit, 65, will be eliminated. For single filers, the phaseout percentage is increased to 15.3% and phaseout amounts are increased to $11,610.

Earned income also excludes child support and alimony, retirement income, Social Security benefits, workers’ compensation benefits, nontaxable foster care payments, veterans’ benefits, and unemployment compensation. A child’s tax-exempt interest and dividend income reported on a parent’s return is also considered disqualifying income.

In 2020, income derived from investments–through rental properties, stock dividends, or inheritance–can not exceed $3,650. In 2021, as a result of the American Rescue Plan, the investment income limit has been raised from $3,650 or less to $10,000 or less. In addition, this $10,000 figure will be pegged to inflation and adjusted accordingly every year going forward. 

The EIC also cannot be claimed if a taxpayer has filed Form 2555 for Foreign Earned Income, which must be filed to exclude income earned in foreign countries from gross income.

In order to qualify for the EIC, taxpayers must have a valid Social Security number by the tax return due date, be a United States citizen or resident alien for the entire year, and the filing status cannot be married filing separately. Children must meet the relationship, age, residency, and joint return tests, and can’t be claimed by more than one person.

If a taxpayer does not have a qualifying child, they must be at least age 25 but under age 65, cannot be the dependent of another person, and must have lived in the United States for at least half of the year. Income earned for work performed while an inmate in a penal institution is also disqualifying income when calculating the EIC.

Taxpayers are disqualified from receiving the EIC if they receive more than a certain amount of income, which is adjusted annually for inflation. For unmarried taxpayers filing individually in 2020, adjusted gross income was required to be less than $50,954 with three or more qualifying children, $47,440 with two qualifying children, $41,756 with one qualifying child, or $15,820 without qualifying children. For married taxpayers filing jointly in 2020, the maximum income to claim the credit was $56,844 with three or more qualifying children, $53,330 with two qualifying children, $47,646 with one qualifying child, or $21,710 without qualifying children.