A tax credit is a taxpayer’s best friend. Those Americans blessed to be filing their taxes with the beloved Internal Revenue Service might qualify for one or more tax credits that could help them minimize their tax liabilities and secure a lower tax bill or even get a refund check.
The IRS offers many different types of tax credits, and most are family-friendly, such as the popular Child Tax Credit and Federal Adoption Credit. Just remember that tax credits work differently and are more valuable than tax deductions.
What Is a Tax Credit and How Does It Work?
A tax credit can help reduce your tax liability dollar-for-dollar — that’s key. In comparison, a tax deduction only reduces the amount of your taxable income.
For example, a tax credit means that if you owe $1,000 in taxes but qualify for a $400 tax credit, your tax liability would be $600. But a $400 tax deduction would reduce that $1,000 tax by only $100. That’s because on average, only 25 cents of each dollar of a deduction is applied when reducing your taxable income.
Tax credits are both lifestyle- and income-specific.
In other words, if your adjusted gross income (AGI) rises to a certain income level, the tax credit is either phased out or eliminated entirely.
How Tax Credits Work When You Have Zero Tax Liability
Taxpayers who have reduced their tax liability to zero before using tax credits can’t always claim their full value.
The IRS breaks down tax credits into two categories: refundable and nonrefundable. With refundable credits, taxpayers receive rebates up to the full value of the credit, even beyond a zero tax liability. Nonrefundable credits count only against your tax liability. Zero means zero in tax refunds. The federal government does offer partial refunds on some tax credits, though.
Popular Types of Tax Credits
I took a look at the seven most popular types of tax credits most people should keep in mind:
1. Child Tax Credit
For millions of taxpayers with children under age 17, the Child Tax Credit is a biggie. Last year, Congress used the Tax Cuts and Jobs Act to double the credit to $2,000 per child. Have five little mouths to feed that you claim as dependents on your tax return? You could get as much as $10,000.
This credit is partially refundable if you have zero tax liability. If you find yourself in this situation, you’ll only get $1,400 of credit per child. The income thresholds to claim the full credit are $200,000 for single filers and $400,000 for married couples filing jointly. I’m looking at getting $4,000 for 2018, thanks to my two boys.
2. Child and Dependent Care Credit
The Child and Dependent Care Credit is designed for parents who work or attend school and who paid for daycare, a babysitter, summer camp, or other providers (such as maids and cooks) to care for a child age 13 or younger or a disabled dependent of any age.
However, this credit carries a lot of restrictions. For example, you can’t claim it if you paid for the service under the table.
Plus, if your income is $15,000 or less, the most the tax credit will cover is 35 percent of qualifying expenses of $3,000 for one child or dependent, or up to $6,000 for two or more children or dependents.
The IRS caps the credit at a 20 percent rate for those who have an annual income of more than $43,000. Even wealthy taxpayers can claim the nonrefundable tax credit.
3. Federal Adoption Credit
Sticking with the kid-friendly theme, adopting a child can be a very expensive process, and those high costs can scare away potential parents.
With the adoption credit, taxpayers can claim up to about $14,000 in expenses for court costs, travel, and other fees for adopting a child under 18 years old. You could adopt, say, six kids — like my wife’s parents did — and claim the credit for each child.
This nonrefundable credit has income restrictions, though. It starts to phase out at $211,160 and it vanishes at $251,160 regardless of filing status.
4. Earned Income Tax Credit
This is another popular tax credit. It’s a godsend for low-income workers or families who are struggling to make ends meet.
Depending on the taxpayer's income, marital status, and number of kids, the Earned Income Tax Credit is worth anywhere from $529 (a family with no dependents) to $6,557 (a family with three or more kids). Income restrictions range from $15,570 (a single head-of-household taxpayer with no dependents) to $55,952 (married with three kids). And it’s refundable.
But strangely, if you make more than $3,600 in income from your investments, you don’t qualify.
I’d like to see the data on the folks who are fortunate enough to have significant stock market investments and who boldly claim what is really a working person’s tax credit.
5. American Opportunity Tax Credit (AOTC)
The AOTC is one of two education-focused tax credits. A student or her parents can get up to $2,500 for tuition, books, equipment, supplies, and fees. That said, it has major restrictions. The student must be pursuing a degree, certificate, or credential and be enrolled in at least six credit hours per semester.
You claim the credit after the student completes four years of post-secondary schooling. If you have zero tax liability, the credit is refundable up to $1,000. The credit phases out at $160,000 and disappears at $180,000 for people who are married filing jointly.
6. Lifetime Learning Credit
This is the other education tax credit, which is far less restrictive than the AOTC. It helps families pay for post-secondary education. This credit provides taxpayers up to $2,000 for tuition, books, equipment, supplies, and fees for undergraduate, graduate, and non-degree courses.
Unlike the AOTC, you don’t have to be enrolled in a formal program or carry a workload. The biggest drawbacks are that the credit is nonrefundable and can’t be used if you take the AOTC. The credit phases out at $116,000 and disappears at $136,000 for joint filers.
7. Retirement Savings Contribution Credit
If you earn less than $65,000 a year, you might want to give this tax credit a look. Basically, it's designed to get people to save for retirement, especially those with modest incomes.
It can be worth as much as $2,000 for couples (or $1,000 for singles). The less you make, the more you can claim for credit if you contribute to a retirement plan like a 401(k) or an individual retirement account (IRA). However, the credit is not refundable.
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Wait, There’s More: Other Types of Tax Credits
These seven types of tax credits are not the end of the matter. But they’re by far the most popular, given how beneficial they can be for families and young people just starting out.
That said, there are other tax credits on the books that may encourage you to purchase an electric vehicle or install solar panels on your roof. States offer their own tax credits, too. For a full listing of each federal tax credit, go to the IRS website.