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 Tax Credits are on a lot of minds as the April filing deadline draws near. Just in case you don't know what a tax credit is, these are a little bit different than tax deductions. If you consider preparing your taxes "fun", then you will enjoy taking tax credits even more than deductions - here's why.
Tax Deductions versus Tax Credits
A tax deduction is something that reduces your tax liability for the year. For example, you can deduct mortgage interest payments from your federal income taxes. When you do so, this lowers your Adjusted Gross Income or AGI. If you paid $10,000 in mortgage interest and you are in the 28% tax bracket, then this deduction lowers your AGI by $10,000. That means you will have to pay $10,000 x 0.28 or $2,800 less in federal taxes.
Tax credits, on the other hand, do not save you taxes by lowering your taxable income. Instead, tax credits act like additional income taxes that are withheld. So if you paid $20,000 in federal income taxes and you are eligible for a credit of $1,000, then as far as the IRS is concerned, you paid $21,000 in taxes. By effectively increasing your federal taxes withheld, you may be eligible for a larger refund.
What this means is that on a dollar for dollar basis, a tax credit is more valuable than a tax deduction. Now that we understand the difference between a deduction and a credit, the next logical question is this - What are some of the more common tax credits?
Federal Income Tax Credits
In general, there are four different types of tax credits that the average taxpayer should be familiar with:
- Child Tax Credits
- Child and Dependent Care Credits
- Earned Income Credits
- Tax Credits involving Higher Education
We explain each of these different types of credits in the sections below, including the amount of credit you can claim on your federal income tax forms as well as how to qualify for a particular credit.
Child Tax Credits
For the tax year 2007, you may be able to claim a child tax credit of $1,000 for each qualifying child. A qualifying child is one that was under the age of 17 at the end of 2007, and is a child that is your own, or that of your brother or sister and is cared by you as your own child. Foster children are also eligible and all these children must be a US citizen or resident.
The child tax credit is phased out if your adjusted gross income is above a certain level. The phase out for each filing status begins:
- $110,000 for Married, filing jointly
- $55,000 Married, filing separately
- $75,000 for Head of Household, Single and Qualifying Widow(er)
Child and Dependent Care Credit
If you care for a dependent that is under the age of 13 or for other dependents that are not able to care for themselves, then you may be eligible for the child and dependent care credit. This credit can be up to 35% of the expenses associated with the care of these individuals. To qualify, you must satisfy all eight of the IRS tests summarized below:
- The care expenses must be for a qualifying dependent, which was defined earlier (under age 13...).
- You must keep up a home that the dependent lives in - paying at least half of the cost associated with owning and running the home.
- You and your spouse (if married), must both have earned income for the year.
- You pay these expenses so that you and your spouse (if married) can work or look for work.
- You are making these payments to someone that you cannot claim as a dependent on your taxes.
- Your tax filing status cannot be married filing jointly or qualifying widow(er) without a dependent.
- You must be able to identify the care provider on your tax form.
- If you exclude or deduct dependent care benefits provided to you by a care plan, then the amount you can deduct is limited to $3,000 if you cared for one person or $6,000 if two or more persons were cared for.
If you think that you qualify for tax credits in this area, then you should consult IRS tax publication P503, which provides a worksheet to calculate the exact credit.
Earned Income Credits
To claim the earned income tax credit, or EIC, you must have earned income but this is subject to limitations. In 2007, your adjusted gross income must be less than $12,590 or less than $14,590 if married and filing a joint return. If you have one qualifying child, then the limited is raised to $33,241 or $35,241 if married and filing a joint return. If you have more than one qualifying child the income level is raised to $37,783 or $39,783 if married and filing a joint return.
There are other qualifying rules, for example, if you have more than $2,900 in investment income, then you cannot claim this tax credit. The tax credits themselves range from $4,500 for taxpayers with two or more qualifying children to $400 for taxpayers without a qualifying child. As was the situation with the Child and Dependent Care Credit, a worksheet is provided on the 1040 tax form to calculate the exact earned income credits.
Education Tax Credits
In 2006 and 2007, there are two tax credits that apply to education - the Hope Credit and the Lifetime Learning Credit. The Hope Credit can only be claimed for two tax years for each eligible student. The maximum Hope Credit is $1,500 and is subject to phase out. You cannot claim a Hope Credit if you AGI is over $53,000 or $105,000 in the case of a jointly filed returns. You cannot claim this credit with a filing status of married and filing a separate return.
In 2007, the Hope Scholarship Credit will increase to $1,650. Also starting in 2007 the phase out for both the Hope Credit and Lifetime Learning credit will begin at $47,000 or $94,000 in the case of jointly filed returns.
The Lifetime Learning Credit is 20% of the first $10,000 you paid for qualifying tuition and related expenses each year. The maximum credit for 2006 is $2,000. Expenses for graduate and undergraduate work are eligible. Unlike the Hope Credit, there is no limit on the number of years that this credit can be claimed; however, it is subject to the same AGI income phase out rules as the Hope Credit.
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