Tax credits can help reduce your liability dollar-for-dollar. That being said, they cannot reduce your income tax liability to less than zero. Simply put, your gross tax liability is the amount you are responsible for paying before any credits are applied.
The majority of tax credits are non-refundable. This means that any excess amount expires the year in which it is used, and is not refunded to you. There are some refundable tax credits, though ― and with these, your refund can grow.
To get a better idea of how tax credits work and whether or not you qualify, you need to know what is available to taxpayers in your situation. Some of the most common tax credits include: credits for child and dependent care expenses, education tax credits, the earned income tax credit, adoption tax credit, and the foreign tax credit.
It’s important to keep in mind that just because you qualify for one tax credit does not mean that you qualify for the rest. For example, the foreign tax credit is only available to those who pay taxes in a foreign country. Most Americans do not fit into this group, but may qualify for other types of credits.
How much are tax credits worth? Again, this depends on the particular credit you’re talking about. The child tax credit, which is one of the most popular, can be worth up to $1,000.00 depending on your situation.
Just as the amount of each tax credit is different, so are the qualification guidelines. Since a tax credit is so helpful to the overall amount of money that you pay, it is essential that you are 100% accurate with this information. In other words, if you are unsure of whether or not you qualify, it is better to check with a tax professional before including the credit on your tax return. Removing a tax credit is going to greatly affect how much you pay in taxes, thus it is better to avoid mistakes than to have the IRS catch them later on.
While tax credits are less common than tax deductions, they are available for things such as adopting a child, buying a first home, child care expenses, and caring for an elderly parent. Additionally, there are many business tax credits that you should also consider.
The main difference is that tax deductions are subtracted from your gross income, while tax credits are subtracted directly from the amount you owe. In short, this means that to be able to claim a tax credit is usually better than a tax deduction.
All in all, both tax credits and deductions can help you pay less income tax. Your goal as a taxpayer should be to take full advantage of every tax credit and deduction that you qualify for. If you are unaware of which tax credits and deductions are available, hire a tax professional to show you the ropes.
Tax Credits vs. Tax Deductions
Tax credits and tax deductions can help reduce your overall income tax liability. Every year, millions of taxpayers search for credits and deductions that can help them save money. While you should take advantage of as many of these as possible, don’t overlook the fact that tax credits and deductions are not the same thing.
Which one is better? Actually, neither is better ― it mainly depends on your particular situation. Both tax credits and tax deductions offer certain benefits. They are two different ways to reduce the amount of tax that you owe. Some people qualify for many tax credits and deductions, whereas others are not able to take advantage of nearly as much.
Tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket. For instance, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 in tax (0.25 x $1,000 = $250).
Tax credits, on the other hand, provide a dollar-for dollar reduction of your income tax liability. For instance, a $1,000 tax credit actually saves you $1,000 in taxes. A tax credit is always worth more than a dollar-equivalent tax deduction, because deductions are calculated using percentages. Referring to the numbers above, you can see that a $1,000 credit offers $750 more in savings than a $1,000 deduction.
Education Tax Credits
Every year we hear about the skyrocketing costs of higher education. Attending college is a major financial commitment and the majority of students do not qualify for scholarships, grants, or other financial aid. Additionally, many adults are going back to school these days in hopes of acquiring more education or training to get a job promotion, earn more money, or find a more rewarding career.
In response, the federal government has created two major education tax credits to help reduce the costs of obtaining a higher education. The American Opportunity Tax Credit (AOTC) is a modified version of the Hope Scholarship Credit. The AOTC provides a maximum $2,500 credit for each student pursuing a degree, for up to 4 years of post-secondary education. The Lifetime Learning Tax Credit offers a credit of up to $2,000 ($4,000 for students in certain disaster areas) for qualified education expenses. Note that the student may elect to receive only 1 education tax credit and certain income limitations apply.
Highlights of both education tax credits include the following:
The American Opportunity Tax Credit (AOTC) Under the American Recovery and Reinvestment Act (ARRA), the IRS modified the education tax credit formerly known as the Hope Scholarship Credit for tax years 2009 and 2010, and created the American Opportunity Tax Credit (AOTC).
The tax credit was extended to apply for years 2011 and 2012 as well.
The American Opportunity Credit is available to a broad range of taxpayers -- including those with higher incomes, no income, and people who owe no tax. Updates to this tax credit have added required course materials to the list of qualifying expenses and allows the credit to be claimed for 4 post-secondary education years instead of just 2. Many of those who are eligible will qualify for the maximum annual credit of $2,500 per student.
The IRS states that the full credit is available to individuals whose modified adjusted gross income (MAGI) is $80,000 or less -- or $160,000 or less for married couples filing a joint return. The credit is then phased-out for taxpayers with incomes above these levels. The American Opportunity Tax Credit is:
- Available for the first 4 years of post-secondary education.
- Allows for a tax credit up to $2,500 per student.
- Up to 40% of the total tax credit may be refundable, meaning that that even people who owe no tax can get an annual payment of the credit of up to $1,000 for each eligible student.
- Covers tuition and fees, and course materials.
The American Opportunity Tax Credit is not available to graduate students who have already completed 4 years of college, although they may still qualify for the Lifetime Learning Tax Credit and the Tuition and Fees Tax Deduction. For details on these and other education-related tax benefits, see IRS Publication 970 (Tax Benefits for Education).
The Lifetime Learning Tax Credit
You may be able to claim a Lifetime Learning Credit of up to $2,000 for qualified education expenses paid for an eligible student. Additionally, there is no limit on the number of years the this tax credit can be claimed.
The Lifetime Learning Credit is a non-refundable credit. This means that it can reduce your tax to zero, but if the credit is more than what you owe in tax, the extra amount will not be refunded to you.
The amount you can claim for this tax credit may be limited based on your income and the amount of your tax. In general, you can claim the Lifetime Learning Credit if all three of the following requirements are met:
- You pay qualified education expenses of higher education
- You pay the education expenses for an eligible student
- The eligible student is either yourself, your spouse, or a dependent for whom you claim an exemption on your tax return
For more information about these types of tax credits, please see IRS Publication 970 (Tax Benefits for Education).