The Child Tax Credit: Don't Make This $6 Billion Mistake

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United States federal income tax return IRS 1040 documents
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Everyone wants to pay as little in taxes as possible, and taking advantage of any available tax credit is one of the best ways to lower your tax bill. But before you claim a credit, you need to make sure that you're doing it correctly. Unfortunately, millions of taxpayers find the tax laws so complicated that they make costly mistakes on their tax returns and later find that they owe far more than they expected.

Last year, the federal government paid out an estimated $5.9 billion to $7.1 billion in improper child tax credit payments, according to a recent audit from the U.S. Treasury's inspector general. The audit said that although some taxpayers deliberately claimed the credit fraudulently, millions more simply made mistakes in determining their eligibility for the credit or claimed the wrong amount.

In order to keep you from making the same mistake when you file your 2014 tax return, you need to know exactly how the Child Tax Credit works. Let's take a look at the provisions of the Child Tax Credit to help you figure out whether you're eligible.

What You Need to Know About the Child Tax Credit

On its face, the credit looks as if it couldn't be simpler. It allows you to reduce your tax by $1,000 for every child you have who's 16 or younger at the end of the year. But as with any tax law, things get more complicated in a hurry.

First of all, there are tests to make sure that you're eligible to claim the Child Tax Credit: To qualify, the child must be a U.S. citizen, who has lived with you for more than half of the year, and be an eligible family member, which includes siblings, nieces, nephews and grandchildren. Legally adopted children also qualify. Also, you must provide at least half of the financial support for the child.

Income limitations can also reduce or eliminate the Child Tax Credit. For joint filers, if your adjusted gross income is more than $110,000, then your credit drops by $50 for every $1,000 you make above that amount. The similar phase-out threshold for single filers is $75,000.

A Credit by Any Other Name

But by far the most confusing thing about the Child Tax Credit is that there are actually two credits that parents can claim. The regular Child Tax Credit is what's known as a nonrefundable credit. That means that you can use it to reduce your net tax liability down to zero, but once your tax for a given year is zero, you can't use any remaining credit to get a direct refund from the IRS.

Because so many families were in a position where they couldn't get the full benefit of the Child Tax Credit, newer tax laws implemented the Additional Child Care Tax Credit. This second credit is refundable, meaning that you can actually get a check back from the government to claim its full benefit.

However, the rules for the Additional Child Tax Credit involve their own calculations. The same $1,000-per-child limit applies, but other limits further restrict your ability to claim a refundable credit. Specifically, as long as you have earned income from wages or salaries of more than $3,000, then you can claim up to 15 percent of the amount over $3,000 for your Additional Child Tax Credit. Those who have three or more qualifying children have the additional alternative of coordinating the credit with their Earned Income Tax Credit if it results in a larger portion of their total Child Tax Credits being refundable.

As a result, it's not surprising to discover that even law-abiding taxpayers have trouble navigating the Child Tax Credit correctly. The Inspector General concluded that further oversight from IRS officials is necessary, and given the billions of dollars involved, those efforts would likely be worth the cost. Yet none of those facts should keep you from claiming and receiving every dollar of the Child Tax Credit that you're eligible to receive. Otherwise, you could end up among the ranks of those who incorrectly choose not to get all the credits they're entitled to -- and cost yourself thousands of dollars in the process.

Motley Fool contributor Dan Caplinger loves to cut his tax bill. You can follow him on Twitter @DanCaplinger or on Google Plus. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.
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