Many people prize tax deductions. The promise of a deduction can affect decisions in many areas, including charitable contributions, home buying, and investing in rental property. However, tax deductions offer only partial relief because they reduce income, not the tax bill. The higher your income and tax bracket, the more you will benefit from a tax deduction.
Example 1: Heidi Jones has recently finished her education and joined the work force. With a modest income, Heidi is in a 15% tax bracket. If Heidi donates $1,000 to charity (and if she itemizes deductions on her tax return), Heidi will reduce her taxable income by $1,000. In a 15% bracket, she will save $150 in tax (15% times $1,000).
Example 2: Ken Larsen, a middle-aged executive, has a high salary, placing him in the 33% tax bracket. If Ken itemizes a $1,000 charitable contribution, he will save $330 (33% times $1,000), more than twice the amount of tax that Heidi saves for the same charitable gift.
Dollar for dollar
A tax credit, on the other hand, is a direct reduction of the tax you owe. If Heidi and Ken both receive a $1,000 tax credit, they will both trim their tax obligation by $1,000. Moreover, many tax credits have income limits and phaseouts. This effectively means they are available to low- and middle-income taxpayers but not to people with relatively high incomes.
Below are some widely used individual income tax credits.
Earned income tax credit
This credit is designed to help workers, including those with self-employment earnings, who have modest incomes. The good news is that the earned income tax credit (EITC) is refundable.
Example 3: Jim Carter files his 2017 tax return. Without the EITC, Jim would owe $500 in tax. Jim’s EITC amount is $1,200. Therefore, his $500 obligation is wiped out, and Jim would receive a check from the IRS for the $700 balance. (Most tax credits are not refundable, meaning that they do no more than offset any tax obligation.)
Besides having earned income, there are several other hurdles to clear to get the EITC. They include age (at least age 25, but under 65), investment income (no more than $3,450 in 2017), and filing status (married filing separately filers are not eligible).
In addition, there are income limits for the EITC; those limits vary by filing status and by the number of qualifying children. (The definition of qualifying children is very broad for EITC purposes.) This year, for instance, a married couple filing a joint tax return with two qualifying children must have both earned income and adjusted gross income (AGI) of less than $50,597 to get this credit.
EITC amounts vary, as well. The 2017 maximum credit is $6,318 for a recipient with three or more qualifying children.
Child tax credit
For the child tax credit, the definition of a child is a bit more limited than it is for the EITC. Although the EITC can cover students under age 24, the child tax credit does not go beyond age 16. Other requirements apply.
The maximum tax credit is $1,000 for each qualifying child. This credit phases out after the taxpayer’s income exceeds a threshold amount based on his or her income. The threshold amount depends on filing status—to get the maximum credit, for instance, a couple filing a joint return must have modified adjusted gross income (MAGI) of no more than $110,000. Above the threshold, the child tax credit drops by $50 per $1,000 of MAGI. Under a tax code provision known as the additional child tax credit, some of the credit may be refundable, depending on the amount of the taxpayer’s earned income.
Child and dependent care tax credit
As the name indicates, this credit has two broad applications. One is for taxpayers who have children under age 13. The other is for those who have spouses, dependents, or certain other individuals who are physically or mentally incapable of self-care. Either way, the credit is a portion of amounts paid to a caregiver so that the taxpayer can go to work, actively look for work, or go to school.
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To calculate this credit, start by finding the amount spent on qualifying care for a given calendar year. Here, the maximum amount that counts is $3,000 for one qualifying person and $6,000 for two or more people needing care.
However, this maximum credit amount may be limited for some individuals. The maximum amount is limited, in the case of a single individual, to the individual’s earned income for the year. In the case of a married individual, the maximum amount is limited to the lesser of the individual’s earned income or the earned income of the individual’s spouse. In addition, if the individual receives dependent care benefits that he or she excludes from income, the maximum credit amount is reduced by the amount of the dependent care benefits excluded.
This resulting amount is multiplied by a percentage that depends on your AGI. The minimum percentage, used by many who claim this credit, is 20%, which applies when AGI is $43,000 or more.
Example 4: Paul and Robin Scott, who have $100,000 in AGI, pay over $6,000 to caregivers for their two children this year. Therefore, the Scotts multiply the maximum amount ($6,000) by the minimum percentage (20%) to get $1,200, the amount of this tax credit they can claim. (Claimants may also be responsible for payroll tax reporting in some situations.)
More tax credits, more assistance
Many other tax credits are available, including some for higher education. For all of them, the rules go beyond these brief descriptions. Our office can help you plan to make the most of these dollar-for-dollar tax savers.