What Are Tax Credits & How Do They Lower Your Tax Bill?
Tax credits can help reduce your liability dollar-for-dollar. That being said, they generally 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.
What Is a Tax Credit?
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.
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. However, there are some refundable tax credits, and with these your refund can grow.
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, is usually worth up to $2,000 per qualifying child. However, the American Rescue Plan Act of 2021 temporarily expanded and increased the Child Tax Credit for many families.
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 affect how much you pay in taxes, so 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 health insurance premiums, adopting a child, buying a first home, child and dependent care expenses, and caring for an elderly parent. Additionally, there are many business tax credits that you should also consider.
Tax Credits vs. Tax Deductions
Both 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.
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 being able to claim a tax credit is usually better than a tax deduction.
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 24% tax bracket, a $1,000 deduction saves you $240 in tax (0.24 x $1,000 = $240).
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 $760 more in savings than a $1,000 deduction.
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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.
The federal government offers some tax breaks for education expenses. There are 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 four years of post-secondary education. The Lifetime Learning Credit (LLC) offers a tax credit of up to $2,000 for qualified education expenses. Note that the student may elect to receive only one education tax credit and certain income limitations apply.
Here are some highlights of these education tax credits:
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 and created the American Opportunity Tax Credit (AOTC). 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. Many of those who are eligible will qualify for the maximum annual credit of $2,500 per student.
The American Opportunity Tax Credit is available for the first four years of post-secondary education. Up to 40% of the total tax credit may be refundable, meaning that that even people who owe no tax can get their excess credit paid to them as a tax refund. 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.
According to the IRS, to be eligible for AOTC, the student must:
- Be pursuing a degree or other recognized education credential
- Be enrolled at least half time for at least one academic period beginning in the tax year
- Not have finished the first four years of higher education at the beginning of the tax year
- Not have claimed the AOTC or the former Hope credit for more than four tax years
- Not have a felony drug conviction at the end of the tax year
The American Opportunity Tax Credit is not available to graduate students who have already completed four years of college, although they may still qualify for the Lifetime Learning Tax Credit.
RELATED: Tax Breaks for Education
Lifetime Learning Credit (LLC)
You may be able to claim a Lifetime Learning Credit of up to $2,000 for qualified education expenses paid for an eligible student. There is no limit on the number of years the this tax credit can be claimed.
The Lifetime Learning Credit (LLC) 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 paid to you as a tax refund.
The amount you can claim for this tax credit may be limited based on your income and the amount of your tax. According to the IRS, to claim a LLC you must meet all three of the following:
- You, your dependent or a third party pay qualified education expenses for higher education
- You, your dependent or a third party pay the education expenses for an eligible student enrolled at an eligible educational institution
- The eligible student is yourself, your spouse or a dependent you listed on your tax return
For details on these and other education-related tax benefits, see IRS Publication 970 (Tax Benefits for Education).
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.
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