The IRS determines your responsibility to file based on your gross income, which consists of both earned and unearned income. This is especially important if you can be claimed as a dependent on someone else’s tax return. Your eligibility for certain tax credits and IRA contributions also depends on how much earned income you have. This article will help you determine the difference between earned and unearned income.

Earned Income

       Obviously, any income you earn by working for someone else will be considered earned income. Salaries, wages, tips, professional fees, business income (from self-employment), and farm income all count as earned income. Those are pretty straightforward.

       But there are a few tricky ones. For example, alimony counts as earned income. (I’m talking about true alimony – you can’t count child support for this.) Also, income from partnerships, S corporations, trusts, and estates can only count as earned income if they are considered “non-passive”. For the most part, this means you must have actively participated in the business that provided the income. There are special rules relating to rental real estate on this issue. If you’re not sure about your situation, you need to consult a tax professional. Finally, taxable scholarships and fellowship grants can also count as earned income.

       That’s pretty much it for earned income. One last note – any earned income that you exclude under the Foreign Earned Income rules does not count as earned income for your IRA contributions. Again, this is another complicated situation that may require talking to a tax professional.

Unearned Income

       Calculating unearned income is very important if you can be claimed as a dependent on someone else’s tax return. You’ll want to know how much unearned income you have so you can figure out if you’re required to file a tax return. Also, if you’re looking to make IRA contributions, none of these items will count. Here are most of the items that are considered “unearned income” by the IRS:

• Interest & Dividends
• Capital Gains
• Retirement Income (IRA distributions, pensions, and annuities)
• Rental Real Estate Income
• “Passive Income” from partnerships, S corporations, trusts, and estates
• Unemployment Compensation
• Social Security Benefits
• Gambling Winnings
• Cancellation of Debt
• Excluded Income under Foreign Earned Income rules
• and a few others…

       Your gross income is the combination of both your earned and unearned income. Knowing what counts for these amounts will help you figure out if you are required to file a tax return and if you’re eligible to make IRA contributions.

Get More Tax Tips!

       If you want to get more tax tips, make sure you sign up for free updates to Provident Planning. If you have any questions about earned or unearned income, leave a comment and I’ll do my best to help you!

       With less than a month left to file your federal income taxes, I’m thinking some of you might have a tax question or two you’d like answered. So here’s my offer. You leave your tax question here in the comments or contact me directly, and I’ll answer it! Normally, I’d charge $100/hour for income tax planning and $75/hour for income tax preparation – but I’m offering this service to you absolutely free!!! I’m making this offer available until April 15th, 2010.

       Now just a few rules:

1. Any tax question is fair game. Nothing is too simple or complex!

 

2. Don’t leave any personal information in a comment. They’re available for the entire public to see!!!

 

3. If you contact me directly, I’ll keep any personal information absolutely private. I will reserve the right to use your question in a post on this website, but I will not share any of your personal information on here.

       So what do I get out of this? Well, other than the pleasure of helping my readers, I’ll be answering questions that other people are probably searching for as well. I’ll put the answers in posts on this website, and hopefully people will find those posts when they search for their question. More visits is a good thing for me! (But I’ll send you your answer before the post is published. I schedule my posts in advance, so I don’t want you to have to wait.)

       But you get free tax help at no cost, so what do you have to lose? Leave a comment now or contact me directly!

       Making sure you claim all of your eligible dependents is an easy way to lower your taxes. Each dependent you claim will increase the total amount of exemptions you can apply to your tax return (a benefit of $3,650 per person for the 2009 tax year). Additionally, the number or type of dependents you can claim will affect your eligibility for certain tax credits. It’s also important to make sure you’re not claiming ineligible people as your dependents so you don’t get in trouble with the IRS. Here’s what you need to know:

Who Are Dependents?

       Dependents are either a qualifying child or qualifying relative who depend on you, the taxpayer, for at least 50% of their support (among other qualifications). The key phrase is “qualifying”, which means that they qualify according to the IRS definition – not yours. Just because someone lives with you doesn’t mean they’re automatically your dependent. There are specific requirements they must meet before you can claim them as a dependent on your tax return.

       While the requirements for a qualifying child and qualifying relative are similar, there are some tests that are specific to each type of dependent. We’ll look at the tests for a qualifying child first, and then we’ll look at the tests for a qualifying relative. This can get a bit complicated, so I’ll try to keep it simple and link to IRS resources for the exceptions.

What Are the Tests for a Qualifying Child?

       Use this series of questions to determine if a person can be considered a qualifying child for your tax return.

1. Was the person younger than you or permanently and totally disabled?
    
   If YES, go to question #2. If NO, go down to the tests for a qualifying relative.

 

2. Was the person your son, daughter, stepchild, adopted child, eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of those?
    
   If YES, go to question #3. If NO, go down to the tests for a qualifying relative.

 

3. Was the person under age 19 at the end of the year? OR Was the person under age 24 at the end of the year and a full-time student for some part of each of five months during the year? OR Was the person permanently and totally disabled (regardless of age)?
    
   If YES, go to question #4. If NO, go down to the tests for a qualifying relative.

 

4. Did the person provide over half of their own support for the year? Click here to read through the IRS definition of support.
    
   If NO, go to question #5. If YES, you can’t claim this person as your dependent.

 

5. Did the person live with you as a member of your household for more than half of the year? Note: There are special exceptions for kidnapped children, children that were born or died during the year, certain temporary absences, and children of divorced, separated, or never married parents. Click here to read about the exceptions.
    
   If YES, go to question #6. If NO, you can’t claim this person as your dependent.

 

6. Was the person a U.S. citizen, U.S. national, or a resident of the U.S., Canada, or Mexico?
    
   If YES, go to question #7. If NO, you can’t claim this person as your dependent. Answer YES if you are a U.S. citizen or national and your adopted child lived with you as a member of your household for the year.

 

7. Was the person considered legally married as of the end of the year (December 31)?
    
   If YES, go to question #8. If NO, go to question #9.

 

8. Is the person filing a joint tax return for this year?
    
   If NO, go to question #9. If YES, you can’t claim this person as a dependent. You can answer NO if the person is filing a joint return to claim a refund and no tax liability would have existed for either spouse if they had filed separate returns.

 

9. Is the person a qualifying child of any other person?
    
   If NO, go to question #10. If YES, you can’t claim this person as a dependent unless you are the person entitled to claim the person as a qualifying child (read the IRS guidelines for the special test for a qualifying child of more than one person – you’ll have to scroll down to it).

 

10. Can you or your spouse (if filing jointly) be claimed as a dependent on someone else’s tax return this year? Note: This applies even if the person chooses not to claim you. You must answer YES if they have the option to claim you (or your spouse) as a dependent.
     
    If NO, you can claim this person as your dependent. If YES, you can’t claim anyone as your dependent – no exceptions.

Well that was fun! Now let’s look at the tests for a qualifying relative.

What Are the Tests for a Qualifying Relative?

       Use this series of questions to determine if a person can be considered a qualifying relative for your tax return.

1. Is the person your qualifying child or the qualifying child of anyone else?
    
   If NO, go to question #2. If YES, this person is not your qualifying relative (you should go back up to the tests for a qualifying child).

 

2. Is the person your son, daughter, adopted child, foster child, or a descendant of any of those? OR Is the person your brother, sister, or a son or daughter of either of them? OR Is the person your father, mother, or an ancestor or sibling of either of them? OR Is the person your half brother, half sister, stepbrother, stepsister, stepfather, stepmother, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law?
    
   If NO, go to question #3. If YES, go to question #4. Note: None of the relatives listed in this question have to live with you in order to qualify as your dependent.

 

3. Was the person any other person (besides your spouse) who lived with you all year as a member of your household? Note: There are special exceptions for kidnapped children, children that were born or died during the year, certain temporary absences, and children of divorced, separated, or never married parents. Click here to read about the exceptions.
    
   If NO, you can’t claim this person as your dependent. If YES, go to question #4. Note: A person doesn’t meet this test if at any time during the year your relationship with that person violates local law.

 

4. Was the person a U.S. citizen, U.S. national, or a resident of the U.S., Canada, or Mexico?
    
   If YES, go to question #5. If NO, you can’t claim this person as your dependent. Answer YES if you are a U.S. citizen or national and your adopted child lived with you as a member of your household for the year.

 

5. Did the person have gross taxable income of less than $3,650 in 2009?
    
   If YES, go to question #6. If NO, you can’t claim this person as your dependent.

 

6. Did you provide more than half of the person’s total support for the year? Click here to read through the IRS definition of support.
    
   If YES, go to question #11. If NO, go to question #7.

 

7. Did another person provide more than half of the person’s total support for the year?
    
   If NO, go to question #8. If YES, you can’t claim this person as your dependent.

 

8. Did two or more people together provide more than half of the person’s total support?
    
   If YES, go to question #9. If NO, you can’t claim this person as your dependent.

 

9. Did you provide more than 10% of the person’s total support for the year?
    
   If YES, go to question #10. If NO, you can’t claim this person as your dependent.

 

10. Did the other person(s) providing more than 10% of the person’s total support for the year provide you with a signed statement (Form 2120 – Multiple Support Declaration) agreeing not to claim the exemption?
     
    If YES, go to question #11. If NO, you can’t claim this person as your dependent.

 

11. Was the person considered legally married as of the end of the year (December 31)?
     
    If YES, go to question #12. If NO, go to question #13.

 

12. Is the person filing a joint tax return for this year?
     
    If NO, go to question #13. If YES, you can’t claim this person as a dependent. You can answer NO if the person is filing a joint return to claim a refund and no tax liability would have existed for either spouse if they had filed separate returns.

 

13. Can you or your spouse (if filing jointly) be claimed as a dependent on someone else’s tax return this year? Note: This applies even if the person chooses not to claim you. You must answer YES if they have the option to claim you (or your spouse) as a dependent.
     
    If NO, you can claim this person as your dependent. If YES, you can’t claim anyone as your dependent – no exceptions.

       That covers all the tests for a qualifying child or qualifying relative. I can’t say that was particularly fun for me, and I’m sure it wasn’t for you. But like I said before, it’s important to make sure you’re claiming all the people you can and only those people you’re allowed to claim. If you have any questions, leave them in the comments and I’ll do my best to help you!

More Free Tax Saving Tips!

       If you want to learn more ways to (legally) reduce your taxes, sign up for free updates to Provident Planning. It’ll only cost you a minute of your time, but you might just learn how to save yourself hundreds or thousands of dollars!

       You can lower your taxable income by remembering to deduct the student loan interest you have paid for the year. Deducting that interest can reduce your taxable income by as much as $2,500. Additionally, it will lower your adjusted gross income (AGI) and possibly make you eligible for even more deductions and credits. Here’s what you need to know:

What Counts as Student Loan Interest?

       Student loan interest is the interest you paid on a qualified student loan. There are a few requirements to meet before a loan can be considered a qualified student loan:

1. It must be a loan taken out solely to pay qualified education expenses (tuition, fees, room, board, books, supplies, equipment, and other necessary expenses for attending an eligible education institution – a college, university, vocational, or other postsecondary institution eligible to participate in a student aid program administered by the Department of Education).

 

2. The expenses must have been for you, your spouse, or a person who was your dependent when you took out the loan.

 

3. The expenses must have been paid within a reasonable amount of time before or after you took out the loan. This means the expenses must relate to a specific semester or period of study and the loan proceeds were disbursed any time within the three months before the semester began or three months after the semester ended.

 

4. The expenses were for a student who was enrolled at least half-time according to the school’s standard.

 

5. The loan can’t be from your spouse, brothers, sisters, half brothers, half sisters, ancestors, or descendants. It also can’t come from certain corporations, partnerships, trusts, exempt organizations, or a qualified employer plan (like a 401(k) or similar program).

       If your loan meets all those criteria, you can deduct any interest you pay as student loan interest up to $2,500 per year. Most standard student loans will meet all of these criteria.

Can You Claim the Deduction?

       You can claim the deduction as long as:

1. You’re not filing married filing separately.

 

2. No one else is claiming you as their dependent on their tax return.

 

3. You are legally obligated to pay interest on a qualified student loan.

 

4. You actually paid interest on a qualified student loan.

       You can even count interest paid by other people on your behalf if you’re the person who’s legally obligated to make the payments. The payments other people make are considered gifts to you, and you are treated as if you are paying the interest.

How Much Can You Deduct?

       For the 2009 tax year, the amount of student loan interest you can deduct is generally the smaller of:

• $2,500, or

 

• The amount of interest you paid in 2009

       However, the amount you can deduct is gradually reduced if your AGI before taking the student loan interest deduction is:

• Between $60,000 and $75,000 if you’re filing single, head of household, or qualifying widower, or

 

• Between $120,000 and $150,000 if you’re filing married filing jointly

       If your AGI is over $75,000 or $150,000 (depending on your filing status), then you’re out of luck. No student loan interest deduction for you. To figure out your allowable deduction, you can use this IRS worksheet (at the bottom of the page). (Or you could just use tax prep software…)

Where Do You Claim the Deduction?

       To claim the deduction, enter the allowable amount on line 33 (Form 1040), line 18 (Form 1040A), line 32 (Form 1040NR), or line 9 (Form 1040NR-EZ).

More Free Tax Saving Tips!

       If you want to learn more ways to (legally) reduce your taxes, sign up for free updates to Provident Planning. It’ll only cost you a minute of your time, but you might just learn how to save yourself hundreds or thousands of dollars!