Tax Credits

NOTE:  You DO NOT need to be an itemizer to take advantage of tax credits.

Tax credits are different from deductions.  Tax credits don't reduce Taxable Income (see pages 9-10), but rather reduce actual tax liability.  $1 of tax credit reduces your tax liability number by $1, whereas a dollar of deduction reduces the base Taxable Income number by $1.  $1 of tax credit will save you $1 of tax payable regardless of your marginal tax bracket.  $1 of deduction will reduce your tax liability number as a function of your marginal tax bracket.  We touched on this in Exhibit 2 on page 12.  If I am in the 28% marginal tax bracket, $1 of deduction will save me 28 cents in taxes payable.

Example: Look again at the Example on page 10.  There, Mark and Debbie had $77,600 of Taxable Income and were in the 25% marginal income tax bracket.  If the couple had one more dollar of Taxable Income, they would pay $0.25 more in taxes that year (the last additional dollar of Taxable Income times their 25% marginal rate).  Conversely, if the couple were able to increase their tax deductions by $1, they would have $1 less of Taxable Income and would pay $0.25 less in tax for the year.

How about the effect of tax credits?  Look at the page 12 Example.  Mark and Debbie have an actual income tax liability for the year of $13,020.  If they had $1 of tax credit available to them for the year, it would reduce the tax liability number by a full $1 to $13,019.  The couple's marginal tax bracket would have no affect on the tax credit allowance.

            So you see, $1 of tax credit is much more valuable than $1 of tax deduction.  Therefore, it is very important that we do not miss taking any available tax credits on the Form 1040.  Starting in the 1998 tax year, there are a number of new tax credits available to the middle class in addition to the more popular pre-existing credits.  I will describe the more typical credits for you, but review the Form 1040 Instructions (go to my Web site, click on Tax Planning, then click on IRS Forms and Instructions) to make sure there aren't any less typical credits you may also be entitled to.  Additionally, I will refer you to the right IRS Publications below.

Refundable vs. Non-refundable Tax Credits

There is one more thing that I need to tell you about tax credits before we start looking at the different ones available.  Some tax credits are "refundable" and some tax credits are "non-refundable."

A refundable tax credit acts exactly like the federal income taxes that your employer withholds from your paycheck - a refundable tax credit is first available to wipe out your tax liability for the year and to the extent the refundable tax credit exceeds your tax liability for the year, the excess is actually refunded to you in the form of a check from the government.

A non-refundable credit is one that is only available to offset that year's tax liability.  If it exceeds the tax liability number, it does not generate a refund nor is it otherwise useable (although it may additionally be available to offset social security you paid that year, as I will note below).  In applying a non-refundable credit against your tax liability for the year, you will use it prior to applying federal income taxes withheld by your employer.

Example:  Mark and Debbie have a $1,000 non-refundable tax credit this tax year.  Mark's employer has additionally withheld $1,500 of federal income tax from his paychecks throughout the year.  The couple's income tax liability for the year proves to be $1,400.  The first $1,000 of the $1,400 tax liability is absorbed by the $1,000 non-refundable credit.  The last $400 of the tax liability for the year is accommodated out of Mark's federal income tax withholding.  The couple receives an $1,100 refund check from the government attributable to the over-withheld taxes.

Child Care Credit

If you are a single parent, or married and both spouses work outside the home, you are typically eligible for a nonrefundable credit based on the child care expenses you pay to a caregiver.  If you have two or more children under the age of 13 and pay $6,000 or more in child care expenses your credit could be as high as $2,100.  If you only have one child under the age of 13 and pay $3,000 or more in child care expenses your maximum credit will be $1,050.  If you spend less on child care expenses than the limits noted, you will still be eligible for a credit but of less amount.

There are no Adjusted Gross Income (see pages 9-10) limitations on the availability of the Child Care Credit.  However, as your AGI goes up, your maximum credit goes down.  You will compute the Child Care Credit on Form 2441.  Look at that Form and the Instructions to it in order to establish the exact dollar amount of your Child Care Credit.  Go to my Web site, click on Tax Planning then Forms and Instructions.  Also look at IRS Publication 17, Chapter 33 and Publication 503, Child Dependent Care.

Child Tax Credit

The Child Tax Credit (different from the Child Care Credit we just looked at) is a newer credit starting with the 1998 tax year.  The amount of the credit is $1,000 per child if the child is under the age of 17, a U.S. citizen, and is claimed as a dependent on your tax return.  The credit is fully available for married taxpayers with Adjusted Gross Income (pages 9-10) under $110,000 ($75,000 for single taxpayers).  If one's AGI exceeds those threshold amounts, the child tax credit is quickly phased out.  The Child Tax Credit may be available to you even if you do not owe any federal income tax.  Effective in 2001, the credit becomes partially refundable for families with children.  The credit is refundable up to 10% of a taxpayer's earned income in excess of $10,000 for 2001 through 2003, and 15% of a taxpayer's earned income in excess of $10,750 for 2004 and thereafter.  Families with 3 or more children are permitted to calculate the credit even more liberally since this credit is available to reduce (and generate a refund from) Social Security taxes such families paid in addition to income taxes for the year.

Example:  Mike and Suzie have 4 dependent children under the age of 17.  The couple's combined income tax liability for the year is $1,500.  The couple paid $3,000 in Social Security taxes through withholding.  Mike's employer additionally withheld $1,000 of federal income taxes from Mike's paycheck.  The child credit is available to offset both income tax liability and Social Security tax liability for the year.  The child tax credit of $4,000 (4 children times $1,000) is applied first to wipe out the $1,500 income tax liability for the year.  Additionally, the last $2,500 of the child credit is available to reduce the couple's $3,000 Social Security tax liability for the year to $500.  The couple will get a refund check of $3,500 (the $2,500 of over-paid Social Security tax and the $1,000 of over-withheld federal income tax).

Carefully follow the Form 1040 Instructions and IRS Publication 17, Chapter 36, as you work through this great tax credit for families.

Earned Income Credit

This credit was designed to provide an incentive to less well-to-do citizens to go out and earn wages rather than overly rely on some form of welfare.  If you have two or more dependent children and your Adjusted Gross Income (see pages 9-10) for tax year 2003 is less than $34,692, you may be eligible for the full Earned Income Credit (it quickly phases out thereafter).  If you have only one dependent child, you may be eligible for the full Earned Income Credit if your AGI is less than $30,666.  Furthermore, if you are age 25 through 64 and are not claimed as a dependent on another person's tax return, you may be eligible for a reduced earned income credit even though you have no children if your AGI is less than $12,230.

This is a very valuable type of credit in that it is a fully refundable credit (see page 39).  That is, it is available not only to wipe out your income tax liability for the year but also may generate a refund check back from the government.  This is another situation where you want to read the Form 1040 Instructions and IRS Publication 17, Chapter 33 and Publication 596, the Earned Income Credit, very carefully.  Take your time working through the Earned Income Credit worksheet provided in the Instructions.  Be careful here: there are penalties imposed if you negligently or fraudulently take advantage of the Earned Income Credit and it is the major reason why lower income taxpayers are audited.

Education Tax Credits