In the corporate world, the only number that really matters at the end of the day is the bottom line. For taxpayers, the bottom-line number on their tax returns is just as important.
There are three main components that determine this number: income, deductions and credits. After these first two components have been computed and all deductions subtracted from income, any remaining income is assessed the appropriate amount of tax. But this final number is not the bottom line for many taxpayers, because their actual tax liability can be reduced further dollar-for-dollar by the various tax credits to which they may be entitled.
In this article, we will look at the available tax credits to help you determine which you can use to help pad your wallet.
What Are Tax Credits?
Tax credits are dollar-for-dollar reductions in the amount of tax that you owe to the government. These credits are much more effective at reducing your tax than deductions, because deductions only reduce the amount of taxable income that will be assessed, while tax credits reduce your tax liability.
Tax credits fall into two main categories: refundable and non-refundable. Refundable credits pay back the excess difference to the taxpayer as a refund if the amount of the credit exceeds the total amount of tax that is owed. Non-refundable credits can only be credited against your tax liability for that tax year; any excess amount is lost.
For example, if you owe $1,500 in tax but have a tax credit of $2,000, then you will get a refund of $500 if the credit is refundable and nothing if it is non-refundable. As with deductions, most tax credits have an income threshold phase-out schedule that reduces and eventually eliminates eligibility for the credits for high-income taxpayers.
Refundable Tax Credits
Here are three examples of available refundable tax credits. They are:
- Earned Income Tax Credit - The earned income tax credit is designed to provide a tax incentive for low and lower- middle income wage earners. The amount depends on the taxpayer's income level and number of dependents. (To keep reading about earned income credits, see How can I tell if I'm eligible for an EIC?)
- Additional Child Tax Credit - The child tax credit applies to taxpayers who qualify for the non-refundable child tax credit, but who are unable to claim the full amount due to the limit imposed on non-refundable credits. Taxpayers must usually have more than two dependents to qualify.
- Excess Social Security Tax and Tier 1 RRTA Tax Withheld Credit - This credit applies to taxpayers who have more than one employer and have the full amount of Social Security tax withheld by each employer. If the aggregate amount of Social Security tax exceeds the taxpayer's taxable wage base, then the excess amount withheld will be refunded to the taxpayer. The tax credit is also for railroad employees who paid too much into their tier 1 railroad employee retirement (RRTA).
Non-Refundable Tax Credits
There are quite a few tax credits that fall into the non-refundable category. Some are more common than others, and they differ in amount and complexity. Many of these credits are offered as tax incentives for certain types of activities, such as higher education and adopting a child.
Here is a breakdown of the major non-refundable credits:
- Hope Credit, American Opportunity Credit and the Lifetime Learning Credit - The hope and lifetime learning credits provide a measure of tuition reimbursement for parents (or students) who are paying college tuition and fees. (To read more about this subject, see Clearing Up Tax Confusion For College Savings Accounts and Invest In Yourself With A College Education.)
- Foreign Tax Credit - This credit is designed to reimburse taxpayers for the taxes they pay to foreign governments on investment income realized outside the U.S.
- Adoption Credit - The adoption credit allows taxpayers who adopt children to recoup some or all of costs of the adoption process (which can be very expensive).
- Elderly or Disabled Credit - Taxpayers over age 65 and those who meet the Internal Revenue Service's (IRS) criteria for permanent and total disability are allotted a special credit. Taxpayers must meet income requirements to qualify.
- Child Tax Credit - Perhaps the most common non-refundable credit, this credit is allowed for all taxpayers who can claim qualified dependents. The maximum credit per child is $1,000. (Find out more about child tax credits in How can I use a child tax credit? and How Expanded Kiddie Tax Affects Families.)
- Dependent Care Credit - This credit helps taxpayers defray the costs of paying for childcare services, as long as certain conditions are met. To see the full list of conditions, see the child and dependent care credit page on the IRS website.
- Retirement Saving Contributions Tax Credit - The saver's tax credit is designed to encourage taxpayers who meet income restrictions to save for retirement by providing a reimbursement for their IRA or qualified plan contributions of up to $1000 for an individual or $2,000 for a married couple filing jointly.
- Miscellaneous Credits - An assortment of less-common tax credits exist that a smaller number of taxpayers qualify for, such as:
- Residential Energy Credit
- Qualified Plug-In and Electric Vehicle Credit
- Mortgage Interest Credit
- Health Coverage Credit
- Prior Year Minimum Tax - Individuals, Estates and Trusts Credit
- Credit for Tax on Undistributed Mutual Fund Capital Gains
If you think your situation calls for the use of any of these credits, check the IRS website for further information.
There are a great many rules and provisions regarding the eligibility and limitations of the various tax credits that are available. Make sure that you use every available tool to help keep your hard-earned dollars where they belong - in your wallet.
Find out how to decrease your individual tax burden in our Income Tax Guide feature.