Even better than a tax deduction or personal exemption is a tax credit. A tax credit reduces the amount of taxes you owe dollar-for-dollar. For example, a tax credit of $1,000 cuts your tax bill by the same amount.
With a deduction or personal exemption, the tax savings are only a fraction of the amount. For example, if you are in the 25% income tax bracket and have a $1,000 deduction, your tax savings is $250.
Here are some of the major categories of tax credits:
Earned income credit. The earned income credit is aimed at reducing the tax burden on lower-income taxpayers. To qualify for the EIC in 2009, a person with no qualifying children may earn up to $13,440. (A qualifying child must pass an age, relationship and residency test.)
An unmarried person with one qualifying child may earn up to $35,463. To qualify with more than one child, total earned income may be up to $40,295. Married persons filing a joint with two or more children return may earn up to $43,415 in 2009 without losing the credit.
The Economic Growth and Tax Relief Reconciliation Act of 2001 provides some marriage-penalty relief by increasing the amount of income a married couple filing a joint return may earn without losing the EIC. For the three years that ended in 2005, the income phase-out limit for claiming the EIC increases by $1,000. For 2005 through 2007, it increased by $2,000. After 2007, it increased by $3,000.
If you file for the earned income credit, you must submit Schedule EIC. This can also be found in IRS Pub. 596.
Saver's tax credit. As a result of the 2001 tax law, lower-income workers are eligible to take the new saver's tax credit for making contributions to qualified retirement plans. This tax credit provides an extra incentive to fund a retirement plan.
For single persons, the credit phases out when adjusted gross income reaches $27,750 in 2009. For married taxpayers filing a joint return, the credit phases out when adjusted gross income reaches $55,500. For heads of household, the credit phases out when adjusted gross income reaches $41,625. See IRS pub. 590 for more information.
Child-related credits. The three major child-related tax credits are the tax credit for child and dependent care expenses, the child tax credit (not the same as the first credit) and the adoption credit. (A fourth credit, the additional child tax credit, is available for users of the child tax credit who have three or more qualifying children.)
For 2009, the maximum child tax credit per child is $1,000. The law also makes it easier to receive a tax refund for the credit.
The adoption credit for 2009 is $12,150. You may be eligible for the maximum adoption credit even if you do not adopt a special-needs child. The 2001 tax law increased to $174,730 ($182,180 for 2009) the amount of income you may earn before the adoption credit begins to be phased out.
Education-related credits. The two main tax credits for higher education are the Hope and lifetime learning credits. In 2009, the Hope credit of $1,800 can be used for up to $2,400 of expenses per year that you incur in the first two years of college. The Hope credit is indexed to inflation. The Hope credit can be used for the direct cost of learning but not for room and board expenses.
The lifetime learning credit applies to tuition costs for undergraduates, graduates and those improving job skills through a training program. For 2009, the lifetime learning credit is 20% of up to $10,000 in qualified expenses, or a maximum of $2,000. The lifetime credit phases out for single taxpayers who earn more than $60,000 and for married taxpayers filing a joint return who earn more than $120,000.
The 2001 tax law also coordinates the use of the two education credits with education savings accounts and qualified tuition plans.
You can receive tax-free distributions from education savings accounts or qualified tuition plans without affecting your use of the Hope or lifetime learning credit, provided the credit is not for the same expenses.
Distributions from education savings accounts or qualified tuition plans are excluded from your gross income for purposes of calculating the credit.
First time homebuyer credit. For first time home buyers who purchase a house between April 9, 2008 and June 30, 2009, they may claim a credit of up to 10% of the purchase price of the home not to exceed $7,500. The credit is refundable and must be paid back to the government over the following 15 years. The credit is phased out for people with adjusted gross incomes of $75,000 to $90,000 ($150,000 to $180,000 for joint returns).
Other tax credits that are widely used include credits for elderly or disabled persons, mortgage interest credit and a credit for refurbishing low-income housing.