Identifying which tax credits apply to you can be a big help as you prepare to file your income tax return. Here are the 5 biggest tax credits you might qualify for.
Most people cringe when it’s time to file taxes. They rush through their returns or hire accountants to do the work -- for large fees -- only to feel that the tax code has eaten most of their hard-earned income.
A number of federal tax credits, however, exist to help taxpayers -- primarily those in middle-income and low-income households -- retain more of their earnings. Identifying which credits apply to you will reduce your pain as you prepare to file your income tax return.
"Credits can have a real impact on income," said Thomas Jensen, a financial adviser and managing partner of Vaerdi LLC in Portland, Oregon. "In my work what typically happens is I'll see young professionals -- say, right out of school or who are just not that advanced in financial planning -- they’ll invest $500 in a tax planner or say, 'I'll just do it myself.'
"In general, they don't inform themselves and so they don't take full advantage of their tax situation."
"I like to encourage people, especially low-income people, that they have a retirement account and they regularly contribute to it. Not only do you get to take whatever you put in right off the top of your total income, you also get to take a credit for up to $1,000 for what you contributed."
- Thomas Jensen, financial adviser and managing partner of Vaerdi LLC in Portland, Oregon
Earned Income Tax Credit
One of the most substantial credits for taxpayers is the Earned Income Tax Credit. Established in 1975 -- in part to offset the burden of Social Security taxes and to provide an incentive to work -- the EITC is determined by income and is phased in according to filing status: single, married filing jointly or either of those with children. Eligibility and the amount of the credit are based on adjusted gross income, earned income and investment income.
A person must be at least 25 years old and younger than 65 to qualify. If married, both spouses must have valid Social Security numbers and must have lived in the country for more than six months. If you may be claimed as a dependent on another filer's tax return, you do not qualify.
Those "married filing separately" do not qualify for the EITC, said Louis Barajas, a Santa Fe Springs, California-based financial planner and author who serves many low-to-moderate-income families in his boutique planning firm, Louis Barajas Wealth Planning.
One fact often misunderstood about the EITC is that self-employed taxpayers may qualify for it, Barajas said.
"I have had a lot of people who I have seen need to amend their returns, who were self-employed, who missed out because they didn't think they were eligible," he said. He also has witnessed the reverse: People who had to amend their returns because they filed for the credit but did not qualify, typically because of investment income.
"I had a 58-year-old man who was retired and widowed, earning $8,000 a year," he said. "He was ... living off of interest. If you earn $3,400 or more in 2016 from (investment income), that is considered 'disqualified income' and you cannot qualify for the credit.
"The Earned Income Credit is set up for a service-sector person or blue-collar worker … essentially, someone not earning a lot of money," Barajas said.
American Opportunity Tax Credit
For years, the Hope Credit helped families pay the costs of higher education. Since 2009, that credit has been rebranded and expanded as the American Opportunity Tax Credit.
Under the Hope Credit, taxpayers received a credit for only two years of undergraduate tuition. The AOTC covers four years of post-secondary education. The AOTC also broadens the range of taxpayers who may receive it by increasing the maximum income level.
The full credit is available to people whose modified adjusted gross income is $80,000 or less, or $160,000 or less for married couples filing jointly. These income limits are higher than those for another education credit, the Lifetime Learning Credit.
Depending on your income (the credit drops as income increases), you may receive up to $2,500 of the cost of qualified tuition and course materials paid during the taxable year. The student must be enrolled at least half-time for at least one academic period. This credit is available on a per-student basis.
If you opt to include tuition costs and other college-related fees as one of your deductions, you may not claim the American Opportunity Tax Credit in the same tax year. The IRS recommends that taxpayers calculate the effect of both options on their tax returns to see which is most beneficial – the deduction or the tax credit. Tax software will automatically compare the two.
Lifetime Learning Credit
The Lifetime Learning Credit, also established to offset the costs of post-secondary education, differs from the American Opportunity Tax Credit in that it is available for any years of post-secondary education, not just the first four. Also, the credit is available for people not pursuing a degree.
The Lifetime Learning Credit may be as high as $2,000 per eligible student. For 2016 the full credit is available to eligible individual taxpayers who make $55,000 or less, or married couples filing jointly who make $110,000 or less. The credit phases out as income goes beyond these amounts.
Child and Dependent Care Credit
The Child and Dependent Care Credit is there to help defray costs of babysitting or daycare, Jensen said. It's available to people who must to pay for childcare for dependents under age 13 in order to work or look for work.
The credit is also available for the cost of caring for a spouse or a dependent of any age who is physically or mentally incapable of self-care.
Filing status must be single, married filing jointly, head of household or qualifying widow or widower with a dependent child. The credit provides up to 35 percent of qualifying expenses, depending on adjusted gross income.
Savers Tax Credit
The Savers Tax Credit, formerly the Retirement Savings Contributions Credit, is for eligible contributions to retirement plans such as qualified investment retirement accounts, 401(k)s and certain other retirement plans. Taxpayers with the least income qualify for the greatest credit -- up to $1,000 for those filing as single, or $2,000 if filing jointly.
"I like to encourage people, especially low-income people, that they have a retirement account and they regularly contribute to it," Jensen said. "Not only do you get to take whatever you put in right off the top of your total income, you also get to take a credit for up to $1,000 for what you contributed."
For 2016 the maximum income for the Savers Tax Credit is $30,750 for single filers, $46,125 for heads of household with income, and $61,500 for those married and filing jointly. Filers must be at least 18 years old and may not have been a full-time student during the calendar year or claimed as a dependent on another person’s return.
Whom the Credits Benefit
Credits are primarily for low-to-moderate-income earners. At an income of $30,000 to $50,000 a year, an individual’s chances of qualifying for credits can drop significantly, said Tim Clegg, a budget software developer and retired financial coach who provided tax filing guidance in nonprofit Volunteer Income Tax Assistance programs in the Boston area for more than a decade.
"I think of that as the bridge range: $30,000 to $50,000," said Clegg. "In there, you're moved up to a new tax bracket, and people go crazy because their credits are going away and it's scary."
Unless such filers' itemized deductions exceed the standard deduction, they may find themselves in an uncomfortable gray zone of the tax code. In many cases, ineligibility for tax credits could mean the loss of $3,000 to $4,000 at tax season.
“I saw many people who at around $30,000 started losing credits and needing deductions, and the (tax) code is set up to offer one pass and that is home ownership,” Clegg said.
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