What Are Tax Credits, and Which Ones Can You Take?
Qualifying Rules for Some Tax Credits Can Be Complex
Saving money on taxes is everyone’s goal, from minimum-wage workers to multi-millionaires. The Internal Revenue Code is accommodating to some extent, offering a multitude of tax breaks to help you keep a little more of your income in your own pocket each year.
Unfortunately, all those tax breaks can be confusing because each comes with its own set of qualifying rules. Know which tax credits you can claim, which you can’t, and the meaning of all those tax terms associated with them.
Tax Credits vs. Tax Deductions
Tax credits are not the same as tax deductions. Tax credits are much better.
Deductions are subtractions you take off your income. If you earned $50,000 over the course of the year and you have $10,000 in deductions, the IRS will only tax you on $40,000. That’s certainly a good thing, but compare it to tax credits.
You’ve finished your tax return, including taking all the deductions you were entitled to. Now you realize that your tax planning was off and somehow you owe the IRS $1,000. If you’re entitled to claim a tax credit of $1,000 or more…poof. Your tax debt goes away. You don’t owe the IRS anything. If you owe the IRS $2,000 and you’re entitled to a $1,000 credit, now you only owe the difference—$1,000. Credits come off your tax debt, not your income, and they do it dollar for dollar.
Refundable Credits vs. Non-Refundable Credits
Now the situation becomes a bit more complicated because there are two types of tax credits: the refundable variety and those that are non-refundable. Most credits, but not all, are non-refundable, and there's a pretty significant difference.
A non-refundable tax credit can erase any taxes you might owe the IRS, but the IRS won’t be sending you a refund if there’s any credit left over. For example, if you owe $1,000 in taxes after completing your tax return and if you can claim a $2,000 non-refundable tax credit, your tax debt still goes away but the IRS keeps the balance—that remaining $1,000. You can’t carry it forward to future years, and you won’t be receiving cash back for that amount.
Contrast this with a refundable credit. If the $2,000 tax credit you claimed was refundable, it would eliminate your tax debt and the IRS would send you a $1,000 refund for the balance.
The Earned Income Tax Credit
Obviously, refundable tax credits are better, but there are only a few of them. The Earned Income Tax Credit is one of the most popular.
This credit was introduced into the Internal Revenue Code in 1975 with the idea of putting more money into the pockets of low- to moderate-income taxpayers. As the name suggests, you must have earned income derived from working for an employer or being self-employed. If you have more than $3,450 investment or interest income as of 2017, you won’t qualify. You must be at least 25 years old and you can’t yet have turned 65. You must have lived in the U.S. for at least six months of the tax year, and you can’t be claimed as a dependent by any other taxpayer.
If you’re married, you must file a joint return with your spouse.
The amount of the EITC is structured according to how many dependents you have and your income. If you earn too much, you won’t qualify. The more dependents you have, the greater your credit will be. If your income is very low and you have three or more dependents, you could be entitled to an Earned Income Tax Credit of $6,318 as of 2017.
The Child Tax Credit
This is another very popular credit. You could be eligible for $1,000 per child up to $3,000 total if you have kids.
They must be younger than 17, and both you and your children must have Social Security numbers that were assigned on or before the tax due date for the year. Each child must be your biological offspring, your adopted child, a foster child placed with you by a government agency, or your stepchild. If he happens to have any income of his own, he cannot have provided half or more of his own financial support during the tax year. You must claim him as your dependent and he must be a U.S. citizen. He must have lived with you for at least half the year.
As with the Earned Income Credit, you can’t earn too much if you hope to qualify for the full $1,000 credit per child. As of the 2017 tax year, the income limits are $75,000 for single and head of household filers, $110,000 for married couples who file jointly, and $55,000 if you’re married but file a separate return. You must subtract $50 from your tax credit for every $1,000 you earn over these limits.
Technically, the Child Tax Credit is non-refundable, but there’s a catch. If you have at least $3,000 in income, you might qualify for the Additional Child Tax Credit, too, which can put some money back in your pocket. As of 2017, this credit can be as much as 15 percent of your taxable earned income over the $3,000 threshold. If you can claim the Additional Child Tax Credit, you can have at least this much of your original Child Tax Credit refunded to you after any tax debt you might owe is eliminated.
Some Popular Non-Refundable Credits
There are many non-refundable tax credits out there, but some are more common than others.
- If you’re at least age 65 or if you’re disabled, you might be able to claim the tax credit for the elderly and disabled, sometimes called the “Senior Tax Credit.” Again, if you earn too much, you won’t qualify, and the thresholds are pretty low: just $17,500 in adjusted gross income if you’re a single or head of household filer. More complicated calculations come into play if you have non-taxable Social Security or other retirement income. The amount of this credit ranges from $3,750 up to $7,500 as of 2017.
- You might qualify for the Child and Dependent Care Credit if you pay a caregiver to watch over your child or children who are under age 13 so you can work or look for work. You can also qualify if your spouse is incapable of self-care so you must pay someone to care for him or her. This credit can amount to up to 35 percent of your qualifying care expenses, but again, it’s subject to income limitations.
- There are two educational tax credits available in the 2017 tax year: the Lifetime Learning Credit and the American Opportunity Tax Credit. Each allows you to deduct a percentage of what you pay in tuition and related costs for you, your spouse or your dependent to pursue post-secondary education. The amounts of these credits also decrease as your income increases beyond certain limits. Rules determine the nature of educational expenses that qualify toward the credit, including certain fees and mandatory costs. You can claim one of these credits or the other, but not both.
Proceed With Caution
These credits are just the tip of the iceberg and the rules given here are just summaries. Be very sure you’re eligible to claim these tax credits or others before you actually do so. Trying to claim a tax credit that you don’t qualify for can result in an IRS audit, something nobody wants to have to deal with. It’s easy to take a misstep because the rules for most credits are interlocking and complex. If you have any doubts at all, you might want to check with a tax professional before you file your return.
As for those income thresholds, keep in mind that for most credits, they refer to your adjusted gross income or AGI, not the overall amount of money you earned for the year. You can find your AGI on line 37 of your tax return if you file Form 1040, on line 21 if you file Form 1040A, or line 4 on Form 1040EZ.
Your AGI is what’s left after you take certain “above the line” adjustments to income but before you subtract your standard deductions or itemized deductions. And some credits use your modified adjusted gross income instead, although this is the same as your AGI for most taxpayers. Again, if you’re unsure what your MAGI is and you need to know, check with a tax professional.