What Are Tax Credits, and Which Ones Do You Qualify For?
The qualifying rules for some popular 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, each of these tax breaks comes with some unique qualifying rules, and they can help you in different ways. Determining whether you qualify—and whether it's too your advantage—can be confusing.
Tax Credits vs. Tax Deductions
First, understand that tax credits aren't the same as tax deductions. Tax credits are much better.
Deductions are subtracted from your gross income. If you earned $50,000 last year and you can claim $10,000 in deductions, the IRS will only tax you on $40,000. That’s certainly a good thing, but compare this to tax credits.
Let's say that you’ve finished your tax return, taking all the deductions you were entitled to. Now you realize that your tax planning was off and you owe the IRS $1,000. You also realize that you’re entitled to claim a tax credit of $1,000, and…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 due, 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 check for any credit that's 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 gets to keep the balance—that remaining $1,000. You can’t carry it forward to future years in most cases, 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 also send you a $1,000 refund for the balance.
Refundable tax credits are obviously better, but there are only a few of them.
The Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is one of the most popular refundable credits, but it comes with some very strict qualifying rules. It was first 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 to qualify...but not too much of it.
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 a maximum earned income tax credit of $6,431 for the 2018 tax year. This is the return you'll file in 2019. The maximum credit is expected to increase to $6,557 for the 2019 tax year.
If you have more than $3,500 investment or interest income as of 2018, you won’t qualify. You must be at least 25 years old and you can’t yet have reached age 65 if you don't have any dependents. 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 Child Tax Credit
This is another very popular credit, and it's partially refundable. You could be eligible for $2,000 per qualifying child if you have kids.
They must be younger than 17 on the last day of the tax year to qualify for the child tax credit, 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, he must be a U.S. citizen, and he must have lived with you for at least half the year, but temporary absences are OK.
As with the EITC, you can’t earn too much if you hope to qualify for the full $2,000 credit per child, but the income limits are very generous as of the 2018 tax year: $200,000 for single filers and $400,000 for married couples who file jointly. You must subtract $50 from your tax credit for every $1,000 you earn over these limits.
This is a significant increase from 2017, thanks to the Tax Cuts and Jobs Act (TCJA). The limits used to be $75,000 for single and head of household filers, $110,000 for married couples who filed jointly, and $55,000 if you were married but file a separate return.
The child tax credit is partially refundable—you can get up to $1,400 back after it reduces your tax bill to zero. And the TCJA also provides for a $500 non-refundable family tax credit if your child is age 17 or older—too old to qualify under the age rule and therefore preventing you from claiming the child tax credit. The IRS refers to the family tax credit as the "credit for other dependents," and you can claim it for qualifying adult dependents as well.
Some Popular Non-Refundable Credits
There are a lot of non-refundable tax credits out there, but some are more commonly claimed than others.
- If you’re at least age 65 or 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 2018.
- 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 you have a disabled dependent, or if your spouse is incapable of self-care so you must pay someone to care for him. 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 2018 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 education 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.
About Those Income Limits
Most of these limits refer to your adjusted gross income (AGI), not the overall amount of money you earned for the year. Your AGI is what’s left after you take certain allowed adjustments to taxable income to reduce it, but before you subtract your standard deductions or itemized deductions. Your AGI can be found on line 7 of the new 2018 Form 1040.
And some credits use your modified adjusted gross income (MAGI) instead, although this is the same as your AGI for most taxpayers. Check with a tax professional if you’re unsure what your MAGI is.
The Bottom Line
These tax credits are 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 because 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. Check with a tax professional before you file your return if you have any doubts at all.