Obtaining a tax credit is the next best thing to paying no taxes at all. A tax credit is a sum of money that you directly deduct from your taxes—for example, a $1,000 tax credit reduces the amount of taxes you pay by $1,000. This is much better than a $1,000 tax deduction, which only reduces your taxable income. If you’re in the 28% income tax bracket, a $1,000 tax deduction will save you only $280 in taxes (28% x $1,000 = $280). A person in the 28% tax bracket would need $3,571 in tax deductions to save $1,000 in income taxes.
So, how do you get these wonderful tax credits? Congress hands them out to individuals and businesses that do things it wants to encourage. Some credits are just for business; others are for individuals. If you're an individuals who owns a business, you may qualify for both.
Congress has taken a great liking to tax credits in recent years and is adding new ones all the time. Each tax credit is different, with its own eligibility rules and amounts. Most credits are based on the amount you spend, but some have specified maximum annual amounts you can’t exceed. Several credits have income limits and are reduced or not available to people whose income exceeds the limits. You claim tax credits on the second page of your Form 1040. First you figure out your taxes due without any credits, then you deduct from this amount the total of all your credits—a highly enjoyable bit of subtraction. You’ll also need to include with your return a special tax form for each credit you claim—there are different forms for different credits.
A tax credit ordinarily will defray only part of a covered expense, so there’s no point in buying something you don’t really need or want just to get a tax credit. For example, don’t buy a hybrid car to get a tax credit if you really don’t want one. But, if you do need or want the item, the credit will help pay for it by reducing your income taxes.
Among the most popular tax credits for individuals are:
The Earned Income Tax Credit (EITC) helps people who work but do not earn a lot. Working families with incomes below specified levels qualify. You can see if you qualify by using the IRS’s EITC Assistant.
If you have children under 17, you probably qualify for the child tax credit. This credit, which can be as much as $1,000 per eligible child, is in addition to the regular exemption claimed for each dependent. You can complete the IRS’s child tax credit questionnaire to see if you qualify for this credit.
If you pay for someone to care for a child under 13, or a disabled spouse or dependent of any age, so you can work or look for work, you may qualify for the child and dependent care credit of up to $6,000. The IRS has andependent care credit questionnaire you can complete to see if you qualify for this credit.
There are two education credits available: the American opportunity tax credit and the lifetime learning credit. These credits can help parents and students pay for post-secondary education. You can claim either credit in the same year, but not both. Normally, you can claim these credits for both your own tuition and required enrollment fees, as well as those for a dependent’s college education. The opportunity tax credit targets the first two years of post-secondary education. To be eligible, you must be enrolled at least half time. You can also choose the lifetime learning credit, even if you're only taking one course. The IRS has an online education credit questionnaire you can complete to see if you qualify for an education tax credit.
This credit is designed to reward low and moderate income workers who save money toward their retirement by contributing to an IRA, 401(k), or other tax qualified retirement plan. The maximum credit is $1,000, or $2,000 for married couples.
Other tax credits often claimed by individuals include:
You can find links to more information on these and other credits at the IRS Credits & Deductions webpage. Be sure to take all the credits you're entitled to each year. Lots of people fail to do this and end up paying more taxes than they have to.