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.
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:
Earned Income Tax Credit (EITC)
The Earned Income Tax Credit (EITC) helps people who work but do not earn a lot. Working families with incomes below specified levels qualify. This credit was extended for five years under the American Taxpayer Relief Act of 2012.
Child Tax Credit
If you have children under 17, you may 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. There are income threshold phase-out provisions. This credit was extended for five years under the American Taxpayer Relief Act of 2012.
Child Dependent Care Tax Credit
If you pay for someone to care for a child under 13 so you can work or look for work, you probably qualifiy for the child and dependent care credit of up to $6,000. This credit was extended permanently under the American Taxpayer Relief Act of 2012.
American Opportunity Tax Credit (Education Credit)
The American Opportunity Tax Credit (formerly the Hope credit) helps parents and students pay for post-secondary education with a tax credit of up to a maximum of $2,500. Normally, you can claim both your own tuition and required enrollment fees, as well as those for a dependent’s college education. To be eligible, the student must be enrolled at least half time. This credit was extended for five years under the American Taxpayer Relief Act of 2012.
Other Credits Available
Other tax credits often claimed by individuals include:
- Foreign tax credit for people who live and work abroad
- Credit for the elderly or the disabled
- Adoption credit
- Residential energy-efficient home improvement tax credit (including solar energy) (expires at the end of 2013)
- Alternative motor vehicle (including hybrids) credit, and
- Credit for prior year minimum tax.
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.