Most people do not like paying taxes, and don't want to pay any more than the law requires. Identifying all the tax deductions and tax credits that you qualify for can help reduce your tax liability. If you are eligible for refundable tax credits, you can even reduce your tax liability below zero. This means the IRS pays you.
Deductions reduce your tax liability by reducing the amount of income that is taxable. For example, if you have a $1,000 tax deduction and are in the 25 percent tax bracket, your tax liability will be reduced by $250.
A tax credit reduces your tax liaibilty dollar directly. For example, if you had a $1,000 tax credit, your tax liability would be reduced by $1,000. Most tax credits are non-refundable which means they cannot reduce your tax liability below zero. In the example if you had a $1,000 tax credit but only $750 in tax liability, then your tax credit would only be $750.
A refundable tax credit can reduce your tax liability below zero and provide you with a refund. Using the previous example of a $1,000 tax credit but only $750 in tax liability, you would receive a $250 refund if the tax credit is refundable. You can identify refundable tax credits by the fact that they are listed in the payments section of Form 1040.
For reducing your tax liability and receiving a refund, a refundable tax credit is preferable to a nonrefundable tax credit, and a nonrefundable tax credit is preferable to a deduction. This doesn't matter much, though, since you can only take the deductions or credits that you qualify for. You do not usually have a choice of taking either a credit or deduction. A refundable tax credit is generally more difficult to qualify for than a tax deduction. Here are some of the common refundable tax credits.
• The Earned Income Tax Credit is for people earning less than $49,078 from wages, self-employment, or farming. Millions of workers who saw their earnings drop in 2011 may qualify for the first time. Income, age, and the number of qualifying children determine the amount of the credit, which can be up to $5,751. Workers without children may also qualify. For more information, see IRS Publication 596, Earned Income Credit.
• The Child Tax Credit is for people who have a qualifying child. The maximum credit is $1,000 for each qualifying child. You can claim this credit in addition to the Child and Dependent Care Credit. For more information on the Child Tax Credit, see IRS Publication 972, Child Tax Credit.
• The American Opportunity Tax Credit is for eligible taxpayers who make less than $80,000, or $160,000 for married couples filing a joint return. The credit is gradually reduced, however, for taxpayers with incomes above these levels. The credit can be claimed for qualified tuition and related expenses that you pay for higher education in 2009 and 2010. Qualified tuition and related expenses include tuition, related fees, books, and other required course materials.
When preparing your taxes, make sure to determine whether you qualify for any refundable tax credits. Not only can they reduce your tax liability to zero, they can pay you money.
Andy Hough writes about frugality and living well on a small income at TightFistedMiser.com.