Many of us know that tax deductions can help take the sting out of what we need to pay the IRS. But did you know that tax credits often provide more of a punch in reducing what you will owe? There are many tax credits available that can benefit taxpayers of all ages and situations, especially those with lower or middle-class incomes.
Read on to learn more and see what credits you may qualify for.
Tax Credits and Tax Deductions: What’s the Difference?
Both tax credits and tax deductions reduce how much you pay in taxes. But tax credits provide you with a dollar-for-dollar refund on your tax owed. So, if you owe $6,000 in taxes but are eligible for $3,000 in tax credits, your ultimate tax bill will fall to $3,000.
Tax deductions, on the other hand, reduce the amount of your income that is taxable. So if you earn $50,000 a year and have $8,000 worth of deductions, your taxable income drops to $42,000. Put another way, if you’re in the 24% tax bracket, a deduction of $10,000 saves you $2,400 in taxes.
Types of Tax Credits
Generally, the government offers tax credits to give financial incentives to encourage behaviors deemed beneficial, such as higher education or homeownership. There are also credits for lower-income individuals, so if your income dropped in 2020, you may be eligible for certain credits for the first time.
But not all tax credits are the same. There are three basic types: nonrefundable, refundable, and partially refundable:
- Nonrefundable: A nonrefundable tax credit can only take your tax liability to zero. So if you owe $3,000 in taxes but are eligible for $4,000 in tax credits, your tax bill will fall to zero, but you won’t get a refund of $1,000.
- Refundable: As the name implies, if your refundable tax credits exceed your tax liability, you’ll receive a refund. So in the example above, a person with a refundable tax credit of $4,000 would also receive a $1,000 refund from the IRS.
- Partially refundable: With a partially refundable credit, you can use the full amount of the credit to take your tax liability to zero. After that, you’ll be eligible for a refund based on a percentage of the outstanding credit amount. For example, the American opportunity tax credit, used for higher education expenses, lets you take 40% of the credit amount remaining after your tax liability hits zero.
Tax credits tend to fall under categories. Review the list of the most popular and commonly used credits below to see what you may be eligible for. Visit the IRS site for a full list of credits and deductions. Also, keep in mind that many states offer tax credits that can be applied when you file your individual state’s return.
Family and Dependent Tax Credits
The IRS offers numerous tax credits to lessen the tax impact of working individuals and families, with and without children. If your income took a hit in 2020, you might qualify for the EITC.
Earned income tax credit (EITC) - The EITC is designed to give tax relief to low and middle-income taxpayers. For the 2020 tax year, single earners who earned between $538 to $15,820 are eligible for the credit. The EITC is a refundable credit.
The EITC income limit goes higher for taxpayers with children. For example, a married taxpayer with three children can earn up to $56,844 and still be eligible for the credit.
There is an old joke about children being worth their weight in gold on tax day, April 15. The next few credits show the various ways your children can play a role in lowering your tax bill.
Child and Dependent Care Credit - This credit provides a break for parents paying for the care of children age 12 and under or another person the taxpayer claims as a dependent who cannot take care of themselves. Unlike other credits, there is no income limit on who can take the credit.
Child Tax Credit - With the child tax credit, parents can take up to $2,000 for each child under age 17 who is a citizen. The credit begins phasing out for married couples earning more than $400,000. The credit is refundable, and up to $1,400 of the remaining credit will be issued as a refund once the tax obligation is zero.
Adoption Credit - This nonrefundable credit can grant up to $14,300 per eligible child to help offset the often onerous costs of adopting.
Credit for Elderly or Disabled - Taxpayers who are 65 or older or who retired early due to disability living on limited incomes may be eligible for this credit.
Homeowner Tax Credits
Buying and maintaining your own home can be expensive. These tax credits can help ease the cost of homeownership or creating or managing low-income housing.
Mortgage Interest Credit - This credit is intended to help lower- to middle-income taxpayers afford the cost of a home mortgage. If you qualify, you can receive a tax credit on a portion of the interest you pay on your mortgage.
Residential Energy Efficient Property Credit - With this credit, homeowners can receive a credit for energy-conscious renovations or additions such as adding geothermal heat pumps or solar panels. Note this tax credit isn’t refundable. Other tax credits for environmentally sensitive home improvements include the Nonbusiness Energy Property Tax Credit, which includes upgrades such as insulation and energy-efficient windows.
Low-income Housing Credit - Through this credit, real estate developers and investors receive tax credits for constructing or renovating affordable housing, whether single-family or multifamily units.
If you don’t have access to health insurance through a job, buying your own can be expensive. The Premium Tax Credit offers help to individuals buying health insurance through the Health Insurance Marketplace. The credit can either be received monthly to offset the cost of healthcare premiums or as a credit when you file your taxes. To qualify, your income must fall within a certain range.
Income and Savings Tax Credits
In addition to the Earned Income Tax Credit, described above, there are numerous tax credits to reward saving for retirement and to reimburse overpayment or double payment of certain taxes.
Retirement Savings Contributions Saver’s Credit - It can be tempting to put off saving for retirement if your income is low. However, saving early and regularly is one of the best ways to help build enough savings to retire on.
Through the Retirement Savings Contributions Savers Credit, the IRS provides tax credits to low and middle-income taxpayers who contribute to retirement plans like traditional and Roth IRAs, as well as workplace retirement plans such as 401(k)s, 403(b)s, and the Thrift Savings Plan for government employees. The contribution limit is capped at $2,000 for single filers ($4,000 for married couples) and will reimburse 50%, 20%, or 10% of your contribution, depending on your adjusted gross income for that tax year.
Foreign Tax Credit - This credit allows you to claim credit for taxes paid on income or investments to a foreign country that were also subject to U.S. taxation. This tax credit is commonly claimed by Americans living abroad as expatriates.
Undistributed Capital Gains Credit - Many of us own mutual funds in our portfolios. If the mutual fund retains any of the capital gains instead of distributing to shares and then pays a tax on those gains, you are eligible to claim a credit for those taxes paid.
Credit for Prior Year Minimum Tax - The Alternative Minimum Tax, or AMT, is intended to ensure higher-earning taxpayers pay a minimum amount to the government, regardless of how many deductions they qualify for. If you paid the AMT in a prior year but do not have to pay the AMT in the current tax year, you may be able to claim this credit.
You’re likely aware of the soaring cost of higher education. However, a college degree is often required to enter high-paying fields or to make a career shift. Thankfully there are tax credits that can help ease the burden of tuition bills.
Lifetime Learning Credit - The Lifetime Learning Credit (LLC) provides up to $2,000 annually in nonrefundable tax credits that can offset the cost of undergraduate, graduate, or professional degree courses. As the name implies, you can claim the credit for an unlimited number of years that you qualify. Your eligibility for the credit phases out past certain income levels.
American Opportunity Tax Credit - This credit is for students in their first four years of higher education and offers up to $2,500 a year for eligible students. The credit is refundable up to 40 percent of the remaining amount, or $1,000, once your tax bill hits zero.
Work with a Knowledgeable CPA Through Taxfyle
Many of us may be eligible for one or more tax credits. Taxfyle matches you with a qualified and knowledgeable CPA who can ensure you’re maximizing the credits and deductions available to your specific situation. Connect with one today!