Updated October 7, 2021
A tax credit allows you to deduct a certain amount of money from the taxes you owe. This is in distinction to a tax deduction, which allows you to lower your taxable income. Tax credits are available to taxpayers for a variety of reasons.
5 Popular Tax Credits You May Qualify For
- Child Tax Credit
- Travel Tax Credit
- Earned Income Tax Credit
- American Opportunity Tax Credit
- Premium Tax Credit
Two of the main reasons the government issues tax credits: to promote certain types of behaviors or to lessen the burden of taxes on financially disadvantaged taxpayers. Tax deductions are often similarly motivated, but in most cases are financially less valuable. This is because a tax credit’s value is dollar-for-dollar, while a tax deduction reduces gross income, which will still be taxed at an individual’s marginal tax rate.
What is a Tax Credit?
A tax credit is an amount of money a taxpayer can subtract from their owed taxes. There are three types of tax credits: a nonrefundable tax credit, a refundable tax credit, and a partially refundable tax credit.
Nonrefundable tax credits are only valid in the current tax year, meaning they cannot be carried over to future years. While a taxpayer can continue to subtract the amounts of their non refundable tax credits from their taxes owed until their tax burden is zero, if any nonrefundable tax credits remain, they do not translate to a cash refund.
Refundable tax credits are arguably the most beneficial type of tax credit for taxpayers because they are paid in full. That means, for instance, if the amount of the refundable tax credit is greater than the taxes owed, the extra dollar amount beyond zero translates to a cash refund.
Partially refundable tax credits are somewhat of a blend between the two aforementioned categories. These types of tax credits are refundable, so the taxpayer will get a refund if the credit amount is greater than the taxes owed, but they will not get the whole amount. Instead, they will get a percentage of the remaining credit or a fixed dollar amount, regardless of how much of a tax credit remains.
Tax Credit Example
To make the distinction clear, we’ll look at someone with $60k of taxable income produced through self-employment or business ownership. An itemized deduction, like a business expense, would go on their tax return, specifically Form 1040 Schedule C.
In this example, spending $10k on a business would lower the adjusted gross income to $50k. The self-employment tax rate is 15.3 percent, so that means a tax burden of $9,180. However, this taxpayer can find additional tax relief through a tax credit program.
As mentioned, a state or federal tax credit does not lower adjusted gross income, but is subtracted dollar for dollar from the individual income tax owed. A child credit, for instance, might lower someone’s taxes by $3k, making taxes owed $6,180.
5 Popular Tax Credits You May Qualify For
Child Tax Credit
The Child Tax Credit is meant to defray the cost of childcare expenses. For the 2021 taxable year, taxpayers can claim up to $3k of expenses per dependent under the age of 18 and $3,600 for dependents under the age of 6.
The child tax credit was previously partially refundable, with taxpayers able to claim up to $1,400 per child for any excess credit amount. This tax credit was designed to assist families whose tax burden was lower than the amount of the credits they could claim.
The American Rescue Plan act of 2021 made some changes to this tax credit, including making it fully refundable and payable in advance. In 2022, barring any extensions to this temporary legislation, the Child Tax Credit will return to its previous rules of $2k per child under the age of 17 for a partially refundable credit, with the refundable portion (called the Additional Child Tax Credit or ACT) capped at $1,400 per qualifying child.
There is a similar type of tax credit called the dependent care credit. This tax credit is meant to defray the burden of dependent care—someone who lives with you and for whom you provide at least 50 percent financial support.
Both children and adults can be recipients of dependent care. Adults can include parents, relatives, or even someone who has lived with you all year, as long as their income falls below $4,300 annually and as long as they have not been claimed as a dependent by someone else.
You cannot claim a spouse as a dependent. A federal credit tax break for a child dependent can include biological children, step-children, foster care children, and even siblings, as long as they are under age 19, or under the age of 24 and attending school five months out of the year.
Travel Tax Credit
The American Tax Rebate and Incentive Program (TRIP) introduced by Senator Martha McSally of Arizona would provide a tax credit to Americans traveling at least 50 miles from their home within the United States and/or its territories and during the years 2020 and 2021.
As you might guess, the purpose of this tax credit is to stimulate activity in the travel industry, which was particularly hit hard by the COVID pandemic. This tax credit would provide up to $4k for single filers and $8k for joint filers for all travel expenses, with some exceptions—those staying at their own vacation home could not write off its mortgage and taxes as part of the travel tax credit.
Earned Income Tax Credit
The Earned Income Tax Credit is a fully refundable tax credit for working individuals with low to moderate earnings, whether they are employed or self-employed, as long as they are between the ages of 25 and 64 and reside in the United States for at least half the year. The amount of the tax credit depends on several factors, such as income and the number of dependents.
For example, in 2021 a single filer with no dependents making less than $15,980 could claim an earned income tax credit of $543, while a married couple filing jointly with three dependents making no more than $57,414 could claim $6,728. Although the earned income tax credit is available to anyone earning an income and with investment income under $10,000 (as of 2021), it’s just one of the many tax breaks available to self employed individuals. These taxpayers can lower their tax burden by writing off business expenses and subtracting them from their gross income, such as a home office deduction.
American Opportunity Tax Credit
This tax credit is for students or parents of students pursuing a college degree. It allows for up to $2,500 per eligible student, with up to 40 percent (up to $1,000) of the remaining amount refunded should it bring a tax burden beyond zero.
Technically speaking, the AOTC covers 100 percent of all expenses up to $2k, and 25 percent of expenses beyond that, for the first four years of higher education (typically the pursuit of a degree program).
In order to claim the credit, the educational institution must issue Form 1098-T to the student. The filing taxpayer must also make no more than $80k as a single filer or $160k for a couple filing jointly. A reduced credit can be claimed for single filers making between $80k and $90k and couples filing jointly making between $160k and $180k. Taxpayers with an adjusted gross income beyond these dollar amounts cannot claim the AOTC at all.
Premium Tax Credit
The Premium Tax Credit is meant to defray the cost of health insurance for married filing couples and individuals who make too much income to qualify for free medical assistance, but do not have a healthcare insurance plan through a workplace.
These taxpayers must have obtained their insurance through a health insurance marketplace. In many cases, they might qualify for an advance payment made directly to their health insurance provider to lower the monthly payment for ongoing coverage.
The CARES Act
The Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed to ease the financial impact of COVID-19 on Americans. In addition to the stimulus check payments, there are additional tax relief measures provided by the CARES Act.
For business owners, the Employee Retention Credit is a refundable credit against employment taxes with a maximum credit of 50 percent of qualified wages paid out to employees from March 12, 2020, through the rest of the year. As you might guess, the purpose of this particular tax break was to motivate business owners to retain employees and keep business going, which in turn places less burden on states departments of labor (in regard to issuing unemployment payments, etc.).
Other components of the CARES Act include the tax-free nature of the emergency stimulus payments. The American Rescue Plan, signed into law in 2021, extends some of the CARES benefits. The child tax credit was increased from $2k to $3k for children under 17, and $3,600 for children under the age of six. Additionally, the entirety of the tax credit is now refundable, whereas previously the refund was capped at $1,400.
This bill also increased the earned income tax credit, along with eliminating the upper age barrier of 65 and lowering the lower age barrier from 25 to 19, in terms of eligibility. There are many other components of the CARES Act, and subsequent legislation that is worth pursuing with an informed accountant in order to take advantage of government tax relief.
Tax Credits Reduce Tax Liability
As you can see, tax credits are designed to either stimulate certain behaviors (like attending college, retaining gainful employment, or traveling), or to provide financial assistance to low and moderate income earners, such as the earned income tax credit (Federal EITC), which provides an additional cash refund.
There is a plethora of information on the internet about each and every tax credit, much of which is available on the IRS website. However, it’s often beneficial to work with a tax advisor who is familiar with tax law and has experience helping individuals prepare their taxes in the most financially beneficial way.
You should also consider tuning in for our weekly Tax Tuesday Webinar, where we talk about the most up-do-date information regarding changes to tax laws and tax credits that impact your annual tax bill.
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