Tax Credits
Ignoring tax credits is like tearing up a paycheck. Unfortunately,
too many people do it. That's unfortunate because each dollar of credit
equals a dollar in tax savings. Deductions are much less exciting. Say
you are in the 28% bracket. Finding a buck's worth of additional write-offs
only saves you 28 cents.
Why do people miss the boat on tax credits? Mainly, because they get
in a big hurry as the dreaded tax-filing deadline approaches. Credits
fall through the cracks because they usually involve making computations
or filling out extra forms. But spending a few more minutes on your
return could net you several hundred dollars. Maybe more. With that
thought in mind, here's a primer on the most common tax credits for
individuals.
AMT Credit
If you paid the dreaded alternative minimum tax in a previous year,
you may have generated an AMT credit. If so, you may now be able to
use the credit to reduce your 2003 tax bill. You definitely earned a
credit if the prior-year AMT hit was triggered by exercising incentive
stock options (a few other things can trigger the credit too). Compute
your credit, if any, using Form 8801 (Credit for Prior-Year Minimum
Tax - Individuals, Estates, and Trusts). Then claim your rightful tax
break on Form 1040, Line 52.
Foreign Tax Credit
If you've worked in a foreign country or have substantial income from
outside the U.S., you probably know all about the foreign tax credit.
It's intended to keep you from being taxed on the same income by two
different countries. But if you simply invested in some international
mutual funds, you may also be able to collect this credit because it's
quite likely you paid foreign taxes last year (whether you knew it or
not). Take a close look at your fund summary statements for 2003. You
will probably have to make some calculations to figure the exact amount
of foreign taxes that came out of your hide. If you have direct holdings
in foreign stocks or bonds, any foreign taxes should show up on Forms
1099-DIV and 1099-INT. Assuming all your foreign taxes came from these
sources and amount to $300 or less, you simply claim your credit on
Form 1040, Line 44. You can have up to $600 of foreign taxes and still
follow this easy procedure if you file jointly. In all other cases,
you must file Form 1116 (warning: it's nasty) to claim your credit.
Credit for Overpaid Social Security Taxes
If you had more than one employer in 2003 and earned over $87,000 in
combined salary, you almost certainly had too much Social Security tax
withheld. You can recover the excess by reporting the overpaid amount
on Form 1040 Line 64. (Technically, this is treated as a tax prepayment,
but the effect on your tax bill is the same as a credit.)
Dependent Care Credit
If you pay someone to take care of your under-age-13 child so you can
work, you could be eligible for the dependent care credit. (If you're
married, your spouse must also work or be going to school.) The credit
percentage ranges from 20% to 35% of qualifying expenses, depending
on your adjusted gross income (AGI). For 2003, the maximum possible
credit for one child ranges from $600 to $1,050; for two or more children
the range is $1,200 to $2,100. You may also qualify if you incur expenses
by taking care of any other dependent who is physically or mentally
unable to care for himself or herself (for example, a disabled parent
or spouse).
The credit is not phased out for high-income taxpayers. However, the
lower dollar limits mentioned above will apply. Fill out Form 2441 (Child
and Dependent Care Expenses) and claim your credit on Form 1040, Line
45. You must supply the name and Social Security number of your care
provider. Failure to do so means the IRS will simply disallow your credit,
recompute your tax and either reduce your claimed refund or send you
a bill for the difference. (Warning: Form 2441 also alerts the IRS that
you may owe the Nanny Tax if you have an in-home care provider. To figure
that amount, use our Nanny Tax Calculator.)
Be careful. You generally can't take this credit if you also contribute
to a pretax flexible childcare spending account through your employer.
So you have to make a choice. The pretax account is usually the way
to go. Since it reduces your taxable salary, it cuts federal and state
income taxes and Social Security and Medicare taxes too. So the effective
tax savings rate will usually exceed the 20% effective tax savings rate
that applies to most people who claim the credit.
Of course, there are a couple of ways to qualify for both breaks. This
can happen if you have one under-age-13 child and contribute less than
$3,000 to your pretax account at work or two or more under-age-13 kids
and contribute less than $6,000. (See Part III of Form 2441 for details.)
Dependent Child Credit
If you had at least one dependent child who was under age 17 at the
end of last year, there's a good chance you are eligible for this one.
The credit is $1,000 per qualifying child. Unfortunately, this break
is phased out starting at adjusted gross income of $110,000 for joint
filers ($75,000 for singles and heads of households and $55,000 for
married people who file separately). Phaseout is complete (meaning you
get zero credit) when AGI exceeds the applicable threshold by $20,000
per child. For example, say you have three qualifying kids and file
jointly. Your credit is completely phased out if your AGI is $170,000
($60,000 above the $110,000 threshold) or more. Assuming you qualify,
there's no form to fill out. However, I recommend reading IRS Publication
972 (Child Tax Credit). Then check the box for each qualifying child
on Form 1040 Line 6c and claim your credit on Line 49.
Note: If you have a modest income, you may be able to treat your dependent
child credit as a "refundable credit." That means you can
collect the full amount of the credit even if it exceeds your federal
income-tax bill (in effect, Uncle Sam pays you the difference). This
is a neat trick when you can do it! See Publication 972 for details.
Hope Scholarship and Lifetime Learning Credits
For the full scoop on these two credits for post-secondary tuition expenses,
see our story, The College Tax Breaks Explained. For 2003, both breaks
are phased out between AGI of $83,000 and $103,000 for joint filers
($41,000 and $51,000 for singles). Say your 2003 AGI was way too high
to claim a credit. All is not necessarily lost. Consider letting your
dependent college-age child claim the credit in your place. You'll have
to forego claiming a dependent exemption for your little student. But
remember: that break is itself phased out between AGI of $209,250 and
$331,750 for joint filers ($139,500 and $262,000 for singles). So you
may actually have little or nothing to lose by blowing off the exemption.
Remember, however, the education credit is worthless to your child unless
he or she earned enough to have a 2003 tax bill. Whoever claims the
credit must fill out Form 8863. The credit is then reported on Form
1040, Line 47.
Adoption Credit
If you adopt an under-age 18 child, you may qualify for a tax credit
of up to $10,160 to offset your adoption expenses. If you are married,
you must file a joint return to qualify. Naturally, Congress imposed
phaseout rules, which cause the adoption credit to vaporize between
AGI of $152,390 and $192,390. If you qualify, claim the credit by filing
Form 8839 (Qualified Adoption Expenses) with your 1040. Enter the credit
amount on Line 50.
Elderly/Disabled Credit
This tax break potentially applies to individuals who: (1) were at least
age 65 at the end of 2002 or (2) were retired on permanent and total
disability. Strict income limits apply, so the credit is unavailable
for many. (In fact, the rules are so strict it's hard to figure out
how anyone can be eligible.) See Schedule R for the details. The credit
goes on Form 1040, Line 46.
Tax Credits
