A tax credit is not the same as a deduction. In fact, they are far more valuable. Unlike a tax deduction, most credits also have income phase out limits, which reduce the number of taxpayers that qualify.
Tax Deductions versus Tax Credits
A tax deduction is something that reduces a tax liability in a given year. For example, it's possible to deduct mortgage interest payments on a federal income tax return. When doing so, this deduction lowers an individual's Adjusted Gross Income, or AGI. An individual in the 28% tax bracket that paid $10,000 in mortgage interest will pay $10,000 x 0.28, or $2,800 less in federal income taxes.
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Tax credits, on the other hand, do not reduce the money owed by lowering taxable income. Instead, credits act like additional income taxes withheld. If someone paid $20,000 in federal income taxes, and is eligible for a credit of $1,000, then as far as the IRS is concerned, they paid $21,000 in taxes. By effectively increasing federal taxes withheld, the individual will be eligible for a larger refund.
Federal Income Tax Credits
In general, there are four different programs the average taxpayer should be familiar with:
Child Tax Credits
Child and Dependent Care Credits
Earned Income Credits
Tax Credits involving Higher Education
Each of these programs is explained in the sections below, including the amount of credit that can be claimed on a federal income tax form, as well as qualifying rules.
Child Tax Credits
For the tax years 2020 and 2021, taxpayers may be able to claim a child tax credit of $1,400 for each qualifying child. A qualifying child is one that was under the age of 17 at the end of the calendar year and is a child of the taxpayer, or that of a brother or sister, and is cared by the taxpayer as their own child; foster children are also eligible. The qualifying rules state all these children must be a U.S. citizen or resident.
The child tax credit is phased-out if adjusted gross income is above a certain level. The phase out limits for this credit includes:
$400,000 for Married, Filing Jointly
$200,000 for Married, Filing Separately, Head of Household, Single, and Qualifying Widow(er)
Child and Dependent Care Credit
Anyone that cares for a dependent that is under the age of 13, or for other dependents that are not able to care for themselves, 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, a taxpayer (claimant) must satisfy all eight of the IRS tests summarized below:
Expenses must be for a qualifying dependent, which was defined earlier (under age 13...).
The claimant must pay at least half of the cost associated with owning and running the home the dependent lives in.
The taxpayer and their spouse (if married), must both have earned income for the year.
These expenses are paid so the taxpayer and their spouse (if married) can work or look for work.
Care payments are made to someone that is not claimed as a dependent on the claimant's tax return.
The tax filing status cannot be married filing jointly or qualifying widow(er) without a dependent.
The care provider must be identified on the tax form.
If the claimant excludes or deducts dependent care benefits provided by a care plan, the amount that can be deducted is limited to $3,000 if caring for one person or $6,000 if two or more persons were cared for.
More information on this topic can be found in IRS Publication 503, which provides a worksheet to calculate the exact credit.
Earned Income Credits
To claim the earned income tax credit, or EIC, an individual must have earned income, subject to limitations. In 2019, a qualifying individual's adjusted gross income must be less than $19,030, or less than $24,820 if married and filing a joint return. Income thresholds phase out for one qualifying child at $41,094, or $46,884 if married and filing a joint return. If there are three or more qualifying children, the income level is raised to $50,162, or $55,952 if married and filing a joint return.
In 2020, a qualifying individual’s adjusted gross income must be less than $19,330, or less than $25,220 if married and filing a joint return. Income thresholds phase out for one qualifying child at $41,756, or $47,440 if married and filing a joint return. If there are three or more qualifying children, the income level is raised to $50,954, or $56,844 if married and filing a joint return.
In 2021, a qualifying individual’s adjusted gross income must be less than $19,520, or less than $25,470 if married and filing a joint return. Income thresholds phase out for one qualifying child at $42,158, or $48,108 if married and filing a joint return. If there are three or more qualifying children, the income level is raised to $53,865, or $57,414 if married and filing a joint return.
Individuals with more than $3,500 in investment income cannot claim this credit.
In 2020, the tax credits themselves range from $6,660 for taxpayers with three or more qualifying children, through $538 for taxpayers without a qualifying child. In 2021, the tax credits themselves range from $7,100 for taxpayers with three or more qualifying children, through $543 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
The Lifetime Learning Credit is 20% of the first $10,000 paid for qualifying tuition and related expenses each year. The maximum credit for 2020 and 2021 is $2,000. Expenses for graduate and undergraduate work are eligible. Unlike the Hope Credit, there is no limit on the number of years this credit can be claimed; however, it is subject to the same AGI income phase out rules.
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