How Do Tax Credits Work? Understanding Your 1040 Tax Credits
Reduce Your Tax Bill With Tax Credits
Tax credits are the best of tax breaks. They come off your income, reducing it so you pay taxes on less earnings, and that's a good thing. But tax credits subtract directly from your tax liability—what you owe the IRS. Their effect is the same as if you had made a tax payment.
Tax credits can erase your tax bill, and some are even refundable, so the IRS will send you cash for any of the credit that's left over after your tax bill is satisfied.
Each tax credit has its own qualifying rules, and they're worth varying amounts.
Available Tax Credits in the 2020 Tax Year
You can claim tax credits for foreign taxes, child care expenses, college tuition and fees, and costs associated with adoption. You might also be eligible for credits based on your age or income, if you contributed to a retirement savings account, or if you have minor children who live with you and require childcare so you can go to work.
The following popular tax credits are in effect as of the 2020 tax year—the return you'll file in 2021.
The Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is refundable credit that's designed to put money back into the pockets of low- and middle-income taxpayers. Strict income limits apply. The maximum credit as of the 2020 tax year is $6,660, the tax return you'll file in 2021, if you have three or more qualifying children.
Childless taxpayers can claim this tax credit, subject to some strict rules, but the American Rescue Plan Act has loosened these rules to a great extent for tax year 2021 in response to the coronavirus pandemic. The Act also increases the maximum credit for childless individuals from $543 to $1,502.
The Child and Dependent Care Credit
The Child and Dependent Care Credit effectively reimburses you for some of what you must pay to a care provider to watch your children or your disabled dependents while you work or look for work. It's up to 35% of up to $6,000 in costs for two or more children, or $3,000 if you have only one child or dependent. Your child must be under age 13 to qualify.
The American Rescue Plan Act also makes some revisions to this credit for tax year 2021. The percentage is increased to 50% for one year only, and the cost limits increase to $8,000 for one child or dependent and to $16,000 for two or more children or dependents.
The Child Tax Credit
Up to $1,400 of the Child Tax Credit has been refundable since tax year 2018, and this will continue to be the case through at least 2025 under the terms of the Tax Cuts and Jobs Act (TCJA).
It works out to $2,000 for each of your children who are age 16 or younger as of the last day of the tax year. Earning too much can disqualify you from claiming this credit, but the income limits are pretty high. Your children must meet several qualifying rules as well.
The American Rescue Plan increases this credit as well for tax year 2021. It's $3,000 for each child age 6 to 17, and $3,600 for children under the age of 6 for one year only. The age limit is increased from 16 to 17 as of the last day of the tax year.
The Credit for Other Dependents
The Credit for Other Dependents was introduced under the TCJA, and it's similar to the Child Tax Credit. It's for dependents who don't meet the age requirements to be a qualifying child, and it's worth $500. It's nonrefundable.
The Adoption Credit
The Adoption Credit reimburses you for up to $14,300 in adoption expenses per child as of the 2020 tax year. It's not refundable, but you can carry over any unused portion of the credit for up to five additional years, applying it to what you owe the IRS in those subsequent years.
The Credit for the Elderly or Disabled
The Credit for the Elderly or Disabled is available to taxpayers who are age 65 or older or disabled. It ranges from $3,750 to $7,500 as of the 2020 tax year, and income limits apply. You won't qualify if you earn too much.
The Saver's Credit
Technically titled the Retirement Savings Contribution Credit, the Saver's Credit rewards you for contributions you make to an IRA or an employer-sponsored retirement plan. It's worth 10%, 20%, or 50% of your qualifying contributions, with a maximum credit of $1,000 or $2,000 if you're married and file a joint return. The percentage you're entitled to claim depends on your income.
The Premium Tax Credit
The Premium Tax Credit goes hand-in-hand with the Affordable Care Act. It's intended to defray the cost of your health insurance premiums. You must purchase insurance through the Health Insurance Marketplace to qualify, and there are income limits in years other than 2021 and 2022. The American Rescue Plan temporarily eliminates these limits.
The American Opportunity Tax Credit
Also referred to as the AOTC, the American Opportunity Tax Credit is for qualified education expenses you pay for yourself, your spouse, or your dependents. The maximum credit is $2,500 per student as of the 2020 tax year. It's a percentage of how much you actually spend on educational costs, and income limits apply.
The Lifetime Learning Credit
The Lifetime Learning Credit is another education credit with somewhat more lenient qualifying rules for students. It's worth up to $2,000 per tax return, not per student.
The Recovery Rebate Credit
Some filers who did not receive the stimulus payment may be eligible for the Recovery Rebate Credit, since this benefit is based on taxpayer's 2020 income tax return, while stimulus check eligibility was based on the level of income reported on 2018 and 2019 returns. If you didn’t receive any Economic Impact Payments or got less than the full amounts, you may thus qualify for the Recovery Rebate Credit and must file a 2020 tax return to claim the credit, even if you don’t normally file. If you're eligible for a credit and don't owe taxes this year, your credit will provide a tax refund.
This list isn't exhaustive, and some of these credits phase out at certain upper income limits. A credit can become less as you earn more, until it's finally eliminated entirely.
Determine Your Tax Liability
Your tax liability is what you owe the IRS after you've prepared your Form 1040 tax return. You can find your gross tax liability on lines 37 and 38 of the 2020 Form 1040, appropriately captioned "Amount you owe."
The IRS has redesigned Form 1040 several times since the 2018 tax year. This information pertains to the 2020 tax return.
Your net tax liability is the tax you're responsible for paying after you claim deductions and apply all the tax credits you're entitled to. Tax credits reduce or eliminate this amount.
Taxes withheld from your pay during the year are a prepayment against your gross year-end tax liability. Self-employed taxpayers are expected to send in quarterly estimated tax payments, based on what they think they'll earn and owe at year's end.
In either case, you'll receive a refund for anything you pay that turns out to be in excess of what you actually owe, or if a refundable tax credit eliminates what you owe, and there's still some left over.
Refundable vs. Nonrefundable Credits
Most credits are nonrefundable, so they're effectively forfeited after your tax bill is erased. They're still great for eliminating or reducing your tax liability, but they don't go any further than that. For example, you'd owe the IRS nothing if you were entitled to $7,000 in nonrefundable credits, and your tax liability were $5,000. Your $5,000 tax debt would be erased by the tax credits, but the IRS would keep that $2,000 balance.
You'll receive a refund for the balance, however, if you have more in refundable credits than you have in tax liability. The earned income tax credit is an example of a refundable credit. Your tax refund will include any extra income tax that was withheld from your pay, as well as any leftover tax credits that didn't go toward erasing your tax debt.
A refundable credit can result in getting more money back from the IRS than you actually paid in through withholding or estimated tax payments.
Your Refund Might Be Delayed
The Protecting Americans from Tax Hikes (PATH) Act of 2015 requires that the IRS delay tax refunds on returns that claim the Earned Income Tax Credit or the refundable portion of the Child Tax Credit. This gives the IRS extra time to detect fraudulent returns.
In most cases, these refunds are released by mid-February.
Carryover Tax Credits
A few credits can be carried from one year to the next so you don't lose any of the excesses, even if they're not refundable. Sometimes they can even be carried back to previous tax years. The foreign tax credit, the adoption tax credit, and the residential energy credit for certain products all allow carryovers or carrybacks as of the 2020 tax year.
Note: Tax laws and forms change periodically. The above information might not reflect the most recent changes. Please consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice, and it is not a substitute for tax advice.