Tax credits subtract directly from what you owe the IRS as you complete your tax return. They’re better than tax deductions because they’re applied dollar for dollar to your tax debt for the year, and some of them can even result in cash back or be carried forward to subsequent years.
The IRS offers a multitude of tax credits that will help you keep a little more of your income in your own pocket each year, but they each come with their own unique, qualifying rules.
What Are Tax Credits?
The federal government offers some tax credits to taxpayers who commit to a variety of things that are deemed to be for the public good, such as adopting a child, saving for retirement, or continuing education. Other credits, like the earned income tax credit, are designed to bolster the economy, putting spendable dollars back into the pockets of low-income taxpayers.
Tax credits relieve some of the tax burden on individuals, allowing them to keep more of their own hard-earned money.
How Do Tax Credits Work?
Tax credits act like payments made to the IRS, just as if you had swiped your debit card or had written a check. If you owe $1,500 in taxes as you finish your return but you qualify for and claim a $1,000 tax credit, you now owe the IRS only $500.
Types of Tax Credits
There are two basic types of tax credits: refundable ones and those that aren’t refundable. Unfortunately, most are nonrefundable.
A nonrefundable tax credit can erase any tax you owe the IRS, bringing your balance down to zero, but the IRS won’t be sending you a check for any part of the credit that’s left over. The IRS gets to keep the balance after your tax liability is erased.
Some credits are set up to allow you to roll any unused portion forward to future tax years.
But if you claim a $2,000 refundable credit and you owe the IRS $1,000, it would eliminate your tax debt and the IRS would send you a $1,000 refund for the balance.1
In either case, the qualifying rules and calculations for each credit can be complex.
The Earned Income Tax Credit
The Earned Income Tax Credit (EITC) was first introduced into the Internal Revenue Code in 1975 with the idea of putting more money into the pockets of low- to moderate-income taxpayers. As the name suggests, you must have earned income derived from working for an employer or from being self-employed to qualify, but you can’t have too much earned income.
The amount of the EITC is structured according to how many dependents you have and your income. You won’t qualify if you earn too much, and the more dependents you have, the greater your credit will be. You’d be entitled to the maximum Earned Income Tax Credit of $6,660 for the 2020 tax year if your income is very low and you have three or more dependents.2 This is the return you’ll file in 2021.
The maximum credit is just a bit less—$6,557—in the 2019 tax year. This is the tax return you’d file in 2020.
The EITC income limits for qualifying as a single taxpayer, qualifying widow(er), or head of household in the 2020 tax year are:
- $15,820 with no qualifying child dependents
- $41,756 with one child
- $47,440 with two children
- $50,594 with three or more children
These thresholds increase for married taxpayers who file joint returns:
- $21,710 with no qualifying child dependents
- $47,646 with one child
- $53,530 with two children
- $56,844 with three or more children3
You must be at least 25 years old to claim this credit and you can’t yet have reached age 65 if you don’t have any dependents.
You must file a joint return with your spouse to qualify if you’re married. And you won’t qualify even if your earned income comes in under the above limits if you have more than $3,600 in investment or interest income.4 You must have lived in the U.S. for at least six months of the tax year, and you can’t be claimed as a dependent by any other taxpayer.5
The Child Tax Credit
You could be eligible for $2,000 per qualifying child if you have dependent children. They must be younger than age 17 on the last day of the tax year, and both you and your children must have Social Security numbers that were assigned on or before the tax due date for the year. This rule went into effect in 2018.
Each child must be your biological offspring, your adopted child, a foster child placed with you by a government agency, or your stepchild. If the child happens to have any income of their own, they can’t have provided half or more their own financial support during the tax year. You must claim the child as your dependent, and the child must be a U.S. citizen and must have lived with you for at least half the year, although temporary absences are okay.
As with the EITC, you can’t earn too much if you hope to qualify for the full $2,000 credit per child, but the income limits are generous: $200,000 for single filers and $400,000 for married couples who file jointly. You must subtract $50 from your tax credit for every $1,000 you earn over these limits.6
This is a significant increase from 2017, thanks to the Tax Cuts and Jobs Act (TCJA). The limits used to be $75,000 for single and head of household filers, $110,000 for married couples who filed jointly, and $55,000 if you were married but filed a separate return. The Child Tax Credit is partially refundable—you can get up to $1,400 back after it reduces your tax bill to zero.7
The Credit for Other Dependents
The TCJA also provides for a $500 non-refundable family tax credit if your child is age 17 or older—too old to qualify for the child tax credit under. The IRS refers to this credit as the “Credit for Other Dependents,” and you can claim it for qualifying adult dependents as well.8
The Senior Tax Credit
You might be able to claim the tax credit for the elderly and disabled, sometimes called the “Senior Tax Credit,” if you’re at least age 65 or you’re disabled. Again, if you earn too much, you won’t qualify, and the thresholds are low:
- $12,500 in adjusted gross income if you’re married, filing a separate return, and you lived apart from your spouse throughout the entire year
- $17,500 if you’re a single filer
- $20,000 if you’re married, filing a joint return, and one spouse qualifies
- $25,000 if you’re married, filing a joint return, and both spouses qualify9
More complicated calculations come into play if you have non-taxable Social Security or other retirement income. The amount of this credit ranges from $3,750 up to $7,500 for tax year 2019.10
The Child and Dependent Care Credit
You might qualify for the Child and Dependent Care Credit if you pay a caregiver to watch over your child or children who are under age 13 so you can work or look for work. You can also qualify if you have a disabled adult dependent who needs care, or if your spouse is incapable of self-care so you must pay someone to care for them.
This credit can be as much as 35% of the qualifying expenses, but it’s also subject to income limits that affect the percentage you can claim.11
Educational Tax Credits
There are two educational tax credits available in the 2019 and 2020 tax years: the Lifetime Learning Credit and the American Opportunity Tax Credit. Each allows you to deduct a percentage of what you pay in tuition and related qualifying costs for you, your spouse, or your dependent to pursue post-secondary education.
The amounts of these credits decrease as your income increases beyond certain limits: $116,000 for married couples filing jointly for the 2019 tax year and $118,000 in 2020.2 Rules determine the nature of educational expenses that qualify. You can claim one of these credits, but not both.
Tax Credits vs. Tax Deductions
Unlike tax credits, deductions are subtracted from your gross income. If you earned $50,000 last year and you can claim $10,000 in deductions, the IRS will only tax you on $40,000. That’s certainly a good thing, but it’s as nice as a dollar-for-dollar reduction of your tax bill.
|Tax Credits||Tax Deductions|
|Reduce the amount you owe the IRS||Reduce your taxable income|
|Do not affect your adjusted gross income (AGI) and eligibility for other credits||Can reduce your adjusted gross income (AGI) to qualify you for other tax breaks|
|Can result in a tax refund for any part of the credit that’s leftover after reducing your tax to zero||Aren’t refundable|
Income Requirements for Tax Credits
Most of the earnings limits mentioned here refer to your adjusted gross income (AGI), not the overall amount of money you earned for the year. Your AGI is what’s left after you take certain allowable adjustments to your taxable income to reduce it, but before you subtract your standard deduction or itemized deductions.
You can find your AGI on line 8b of the 2019 Form 1040.
Some credits use your modified adjusted gross income (MAGI) instead, although this is the same as your AGI for most taxpayers. Some rarely taken deductions are added back in to arrive at your MAGI. Check with a tax professional if you’re unsure what your MAGI is.
Be very sure you’re eligible to claim these tax credits or others before you actually do so, because the rules can be intricate and complicated. You might think you qualify when you don’t, so check with a tax professional if you have any doubts at all so you don’t risk an IRS audit. At the very least, the IRS will reach out to you for corroborating documentation to prove that you qualify.