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Tax Credits - An Overview

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By Roy Lewis

As you know, there are many ways to reduce your taxes. One of the most popular is using tax credits. Tax credits are valuable because they reduce your taxes on a "dollar-for-dollar" basis. Deductions only reduce your taxes on a percentage basis, based on your marginal tax rate, because they reduce the income on which your taxes are calculated, not the actual tax amount. But, credits reduce your actual tax liability directly. Tax credits also can be used regardless of whether you itemize your deductions.

There are a vast number of credits. Many have been around for years, and are quite popular (such as the dependent care credit). Some are new, and provide an exciting way to reduce your tax liability (such as the child tax credit). Others are more obscure to most taxpayers and only apply to special taxpayers in special situations (such as the enhanced oil recovery credit). But, you should know that there are a LOT of credits out there that can help you reduce your total taxes.

Many credits are discussed in greater detail here in the Taxes area. You might want to check 'em out. Other credits, since they are not applicable to the general public, have not been discussed. But, it is important that you know more about these credits and how they work, which is why this overview of credits is presented for your reading pleasure.

Types of Credits

Income tax credits can be broken down into five basic groups:

  1. Nonrefundable personal credits
  2. Miscellaneous nonrefundable credits
  3. Refundable credits
  4. The general business credit, and
  5. The credit for the prior-year minimum tax liability.

Nonrefundable Personal Credits

The nonrefundable personal credits include the household and dependent care credit (commonly known as the child care credit), the credit for the elderly and disabled, the adoption expenses credit, the HOPE and Lifetime Learning education credits, and the home mortgage interest credit.

As their names suggest, these credits are for personal expenses and are applied to reduce your regular tax liability (but not below zero, where a "refund" would result). If there is an excess credit -- an amount you were entitled to that would have resulted in a tax refund -- only the adoption expenses credit and home mortgage interest credit may be carried forward to another tax year.

Miscellaneous Nonrefundable Credits

The miscellaneous nonrefundable credits include the foreign tax credit, the non-conventional source fuels credit, the qualified electric vehicle credit, and the Puerto Rico economic activity credit. Although none of these credits are refundable, any unused foreign tax credit can be carried back as much as two years and forward as far as five years.

Refundable Credits

The refundable credits include: the credit for taxes withheld on wages and other amounts, the earned income credit, and the child tax credit, which are designed to aid low-income taxpayers; the credit for tax withheld on payments to nonresidents and foreign corporations; and the gasoline and special fuels credit. These credits aren't limited by your tax liability. If the amount of the credit you're entitled to is more than your tax liability, the difference can be refunded to you in the tax year in question. You don't have to carry-forward excess amounts.

General Business Credit

The general business credit encompasses a number of credits designed to encourage certain business activities. These credits include the investment tax credit, which consists of the rehabilitation credit, the energy credit, and the reforestation credit; the work opportunity credit; the alcohol fuels credit; the research credit; the low-income housing credit; the enhanced oil recovery credit; the disabled access credit; the renewable electricity production credit; the empowerment zone employment credit; the Indian employment credit; the employer Social Security credit; the orphan drug credit; the trans-Alaska pipeline liability fund credit; the community development credit; and the welfare-to-work credit.

Prior-Year Minimum Tax Credit

The prior-year minimum tax credit is designed to reimburse taxpayers for AMT paid in earlier years as a result of certain "deferral" items. Deferral items are preference items, such as accelerated depreciation, which do not result in a permanent reduction in regular tax liability. The credit is available to individuals, corporations, trusts, and estates. As with any AMT item, the rules for calculating and applying it are complex. For more information, download Form 8827 from the IRS website.

As you can see, there are a number of credits that can be used to reduce your income tax liability. This is only a summary of the available credits. You'll find a discussion of many of these credits here in the Taxes FAQ area. But, if there is a credit noted above that you believe could apply to you, and on which you need a bit more information, you can always post your question in the Tax Strategies discussion board. I'll be glad to provide you with an overview of any specific credit that you might have an interest in.

This forum and the information provided here should not be relied on as a substitute for independent research to original sources of authority. The Motley Fool does not render legal, accounting, tax, or other professional advice. If legal, tax, or other expert assistance is required, the services of a competent professional should be sought. In other words, if you get audited, don't blame us.