Why You Can't Affort to Overlook Tax Credits

February 3, 2005

If you're focused on lowering your 2004 tax bill, don't forget to claim the tax credits to which you are entitled. According to the Virginia Society of CPAs, while both deductions and credits can lower your tax bill, they are by no means created equal. Tax credits are more valuable than deductions in cutting your tax bill. The Society offers the following explanation of the differences and outlines credits you may be qualified to claim on your tax return.

Understanding the tax difference
Whether you itemize or take the standard deduction, tax deductions are used in calculating your taxable income. Deductions reduce your tax bill by lowering your taxable income. The amount you save from deductions depends on your marginal tax bracket. The higher your tax bracket, the more you can save. Tax credits, on the other hand, apply after you have determined your tax liability and cut your tax bill dollar-for-dollar.

Here's an example: For an individual in the 25 percent tax bracket, a $1,000 tax deduction reduces your tax bill by $250. By contrast, a $1,000 tax credit reduces the taxpayer's tax bill, dollar-for-dollar, by $1,000. So, if you owe the IRS $2,000, a $1,000 tax credit cuts your tax bill in half.

Some common tax credits
There are many tax credits; the most common are child- and education-related and many have age implications. Here is an overview:

The child tax credit for 2004 is $1,000 for each qualifying child. The basic requirement is that your child be younger than age 17 at the end of the calendar year and claimed as a dependent on your return.

The adoption credit for 2004 is $10,390 per qualifying child.

The credit for the elderly or disabled is available to individuals who are either age 65 or older or are under age 65 and retired on permanent and total disability.

The child and dependent care credit provides a tax credit of between 20 and 35 percent of qualifying expenses. The credit is available to parents who, in order to work, pay someone to care for a dependent child under 13 or for a relative who is incapable of self-care. For 2004, the dollar limit on the expenses toward which you can apply the credit percentage is $3,000 for the care of one dependent and $6,000 for two or more.

The Hope Scholarship Credit provides a credit of up to $1,500 per student during each of the first two years of college. The credit applies only to tuition and related fees (not room and board) and the qualifying student must be enrolled at least half-time in a college or vocational school.

The Lifetime Learning Credit applies to tuition costs for undergraduate and graduate level courses and also to courses for improving job skills. The credit is equal to 20 percent of your eligible lifetime learning expenses, for a maximum $2,000 credit.

The Earned Income Credit is aimed at reducing the tax burden on lower-income taxpayers. Persons with or without a qualifying child may claim this credit. For tax year 2004, the maximum credit is $2,604 for persons with one qualifying child, $4,300 for persons with two or more qualifying children, and $390 for persons without a qualifying child.

Special rules apply
Many tax credits are reduced or eliminated for higher income taxpayers. In some cases, the credits cannot be claimed simultaneously. For example, you cannot take the Hope Credit and the Lifetime Learning Credit for the same student in the same year. Some credits require that you itemize your deductions and some exclude taxpayers who are married and file separately.

Refundable and non-refundable credits: Know the difference
There are two types of credits: non-refundable and refundable. Non-refundable tax credits can reduce tax to zero, but can't be used to get a refund. Non-refundable tax credits include the dependent care credit, the credit for the elderly or disabled, the Hope and Lifetime Learning Credits and the adoption expenses credit. In most cases, the child tax credit is non-refundable but in certain cases, it is partially refundable for lower-income families.

A refundable credit, such as the Earned Income Credit (EIC), can reduce your tax below zero and provide you with a refund. For this reason, CPAs point out individuals with zero taxable income who are eligible for the EIC should file a tax return to receive the benefits of this credit.

To find out more about these credits, contact a CPA or visit the Internal Revenue Service Web site at www.irs.gov .