Tax season is around the corner, and if you want to reduce how much you pay the government, you need to understand which tax credits you can claim.
“With certain credits, some people will actually get rebates on their taxes,” says Elijah Kovar, partner and finance advisor with Minneapolis-based wealth management firm Great Waters Financial. Known as refundable credits, they will result in a refund if the amount of the credit exceeds the amount of taxes owed. Nonrefundable credits can wipe out a taxpayer’s bill, but won’t result in a tax refund.
Keep reading to learn more about how tax credits differ from deductions and which federal tax credits apply to your situation.
[See: 15 Tax Questions — Answered.]
What Is a Tax Credit?
Tax credits shouldn’t be confused with tax deductions, and a credit is significantly more valuable than a deduction of the same amount. That’s because a tax credit directly offsets taxes owed, while a deduction reduces how much income is taxable.
“A credit is (applied) dollar for dollar against the taxes you owe,” says Paul Joseph, a certified public accountant and attorney with tax preparation provider Joseph & Joseph Tax and Payroll in Williamston, Michigan. For instance, a $1,000 credit will wipe out $1,000 in taxes due. However, the value of a deduction depends on your tax bracket. For those in the 22% tax bracket, a $1,000 deduction will save $220 in taxes.
Because credits are so valuable, the government usually places income limits or other restrictions on who can claim them. These restrictions vary by individual credit. What’s more, both states and the federal government may offer credits for similar expenses, but each have their own eligibility criteria. Overall, the most common credits fall into the following categories: tax credits for college, tax credits for families, tax credits for income-eligible households and tax credits for investments.
Tax credits you may be qualified for include the following:
— American opportunity credit.
— Lifetime learning credit.
— Child tax credit.
— Child and dependent care tax credit.
— Adoption tax credit.
— Earned income tax credit.
— Premium tax credit.
— Foreign tax credit.
— Retirement savings contribution credit.
Keep reading to learn more about these credits and who can claim them.
Tax Credits for College
American opportunity credit. “If you’re in college, there are various tax credits you could be taking advantage of,” says Bryan Bibbo, financial advisor with The JL Smith Group in Avon, Ohio. The most lucrative is the American opportunity tax credit. Parents of dependent students, as well as independent students, may be eligible for a $2,500 per student credit for the first four years of undergraduate education.
To claim the credit, students must be enrolled at least half time for one academic period, be pursuing a degree or other recognized education credential and not have previously claimed an American opportunity credit or Hope credit for more than four tax years. Eligible expenses include tuition, fees and expenses that are required for attendance in class, such as books. Only married couples filing jointly who have modified adjusted gross incomes less than $180,000 can claim the credit; the income limit for those with other filing statuses is $90,000.
Lifetime learning credit. The lifetime learning credit is equal to 20% of qualified education expenses, up to a $2,000 credit per year. In order to be eligible, your modified adjusted gross income cannot exceed $138,000 as a married couple filing jointly or $69,000 as a single filer. There is no cap on how many years someone can receive a lifetime learning credit, and classes don’t have to be part of a degree program.
Tax Credits for Families
Child tax credit. Parents may receive a $2,000 tax credit for each child younger than age 17 who lives with them more than half the year. “If (your child) turns 17, you get $500,” Bibbo says. Married couples filing jointly can have incomes as high as $400,000 before their eligibility phases out, and other taxpayers can have incomes of up to $200,000 and receive the credit.
Child and dependent care tax credit. If you pay for child care so you can work, you may be eligible for the child and dependent care tax credit. The amount of the credit depends on your income, but the maximum amount that can be received is 35% of $3,000 in allowable expenses for a single child, or $6,000 in allowable expenses for two or more children.
Adoption credit. This credit can help reimburse parents for their legal fees and other costs associated with adoption, Kovar says. In addition to a credit of $14,300 for a qualified adoption, taxpayers may be able to exclude $14,300 from their income in 2020 if an employer pays for qualifying expenses. However, the credit and the exclusion can’t be for the same adoption costs. You’ll need a modified adjusted gross income of $214,520 or less in 2020 to receive the complete credit and exclusion. After that, your tax benefits are reduced and then eliminated once your income hits $254,520. The credit is nonrefundable, but you can carry over any unused portion of the credit for up to five years.
Tax Credits for Income-Eligible Households
Earned income tax credit. This tax credit is specifically for low- and moderate-income earners. The maximum credit for 2020 is $6,660 for a household with three or more qualifying children. It’s a refundable credit that could mean thousands of dollars in the pocket of low-income families, Joseph says. Income limits depend on how many children are in a household and range from $15,820 for a single taxpayer with no children to $56,844 for a married couple filing jointly with three or more children. To be eligible for the earned income tax credit, taxpayers are also limited to no more than $3,650 in investment income for the year.
Premium tax credit. Many people receive this credit throughout the year in the form of a health insurance premium subsidy. Created by the Affordable Care Act, it is offered to income-eligible households buying insurance coverage through the government’s health insurance marketplace. The credit is refundable, and the amount each household receives depends on their income and the price of health insurance in their area. Joseph cautions that people need to provide accurate information when completing their health insurance application on the marketplace. “If you make more than you initially reported, you may have to pay back some or all of the credit,” he says.
Tax Credits for Investments
Foreign tax credit. The foreign tax credit allows taxpayers to receive a credit for foreign taxes they pay on income that is also subject to U.S. income tax. Even middle-class families may be eligible to receive this credit if they have invested in foreign mutual funds. Dividends from those funds may be subject to foreign tax, and U.S. taxpayers shouldn’t overlook the chance to receive a credit for those payments. If you have paid any foreign tax, it should be listed on the 1099 tax form you receive from your brokerage.
Retirement savings contribution credit. Also known as the saver’s credit, this credit is available to independent taxpayers who are 18 years or older but not full-time students. “You could get a credit for saving for your own retirement,” Bibbo says. It provides a tax credit of 10%, 20% or 50% of your contributions to an IRA, employer-sponsored retirement plan or ABLE account. To receive the maximum credit, married couples filing jointly can’t have an adjusted gross income of more than $39,000 in 2020. After that, the credit drops to 20% of contributions for couples earning $39,001 to $42,500 and 10% for those with incomes between $42,501 and $65,000.
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Update 12/29/20: This story was published at an earlier date and has been updated with new information.