What are Tax Credits?
Even though the deadline to pay and file your income taxes is delayed, we recommend still filing sooner rather than later if you expect to receive a refund.
As you gather all of the paperwork and documentation needed to prepare and file your tax returns, you may spend a lot of time searching for deductions that can lower your tax bill. While claiming deductions is certainly a viable way to lower taxes, there’s another tax-saving strategy that can be even more effective: claiming tax credits.
The Difference Between Tax Credits and Tax Deductions
Sometimes people lump tax credits and tax deductions together, thinking they’re the same thing, but they’re not. Tax credits can be far more valuable than tax deductions because they lower your tax bill on a dollar-for-dollar basis. Conversely, tax deductions simply lower your taxable income, which also lowers your tax bill but only by the percentage applied by your tax rate.
For example, let’s say you and your spouse earned a combined $100,000 of ordinary income last year, which puts you in the 22% tax bracket. A $1,000 tax deduction will potentially lower your tax bill by $220 (.22 x 1,000 = 220). That’s not bad, but a $1,000 tax credit will lower your tax bill by $1,000 — or nearly five times as much in this example.
Also, with the increased standard deduction rising to $12,200 for single filers and $24,400 for married filers who file joint tax returns, the potential tax savings impact of many popular deductions has been reduced for a number of taxpayers. You would have to itemize deductions on Schedule A (i.e. have qualified deductions above the aforementioned thresholds) in order to gain additional tax savings for tax deductions such as mortgage interest and charitable deductions. However, you don’t have to itemize deductions on Schedule A in order to claim most tax credits, including the Earned Income Tax Credit and Child Tax Credit.
Refundable and Nonrefundable Tax Credits
There are two main categories of tax credits: refundable and nonrefundable. With a refundable tax credit, you can possibly get a refund back from the government even if you have no federal tax liability.
For example, let’s say you owe $750 in federal taxes before figuring in tax credits. But you qualify for a $1,000 refundable tax credit, which brings your tax liability down to negative $250. Since the tax credit is refundable, you will receive a check from the IRS for $250. If the credit were nonrefundable, you would owe zero dollars in federal taxes but you wouldn’t receive anything back from the IRS.
The Most Popular Tax Credits
Here are a few of the most popular tax credits claimed by many Americans:
Earned Income Tax Credit (EITC)
This is the most commonly claimed tax credit, appearing on 18 percent of all tax returns in 2016, according to the Tax Policy Center. The purpose of this refundable tax credit is to help reduce taxes for low- and middle-income working families with children.
If you earned $55,952 in 2019 or less and had investment income of $3,600 or less, you could qualify for the EITC. It could reduce your taxes between $529 and $6,557 depending on how much income you earned, your adjusted gross income level , filing status and the number of qualifying children you have.
Child Tax Credit (CTC)
This is the next-most commonly claimed tax credit, appearing on 15 percent of all tax returns in 2016. The Tax Cuts and Jobs Act increased the CTC from $1,000 to $2,000 per qualifying child and also raised the income threshold at which the credit begins to phase out to $400,000 for married couples filing jointly and $200,000 for single filers.
The CTC is also partially refundable so you could receive a refund of up to $1,400 per qualifying child if you owe zero dollars in federal taxes.
Education Tax Credits
There are two tax credits available to help families offset the costs of higher education. The Lifetime Learning Credit (LLC) is worth up to 20 percent of the first $10,000 (up to a maximum credit of $2,000) in qualifying education expenses for individuals and families that qualify. Eligibility for this credit starts phasing out once your modified adjusted gross income (MAGI) exceeds $58,000 if you’re single or $116,000 if you’re married and file jointly.
The American Opportunity Credit (AOC) is worth up to $2,500 per year spent on qualified education expenses. Unlike the LLC, it can only be claimed during the first four years of college, not for expenses incurred in graduate school. Eligibility for the AOC starts phasing out once your MAGI exceeds $80,000 if you’re single or $160,000 if you’re married and file jointly. The AOC is also partially refundable up to $1,000 while the LLC is a nonrefundable credit.
Also, you cannot claim both tax credits for the same student. If you qualify for both you must determine which credit offers the most financial benefits for you or your family.
This nonrefundable tax credit is intended to help low- and middle-income families save money for retirement. You may qualify for a credit of 50%, 20% or 10% of the first $2,000 ($4,000 if married filing jointly) you contributed to an IRA or 401k in 2019. Your MAGI must be less than $32,000 if you’re single or $64,000 if you’re married and file jointly to qualify.
See if You Qualify
When preparing your 2019 tax return in the coming weeks, don’t forget to check and see if you qualify for any of these tax credits. If you do, you could save thousands of dollars in taxes.
Be sure to consult with a tax professional for guidance in your specific situation.