Tax season has arrived, and when it comes to preparing your return remember this: deductions are good, but tax credits are better.
Anyone who’s paid taxes knows the value of deductions, which reduce the amount of your tax bill at your marginal tax rate. If you’re in the 22% federal tax bracket and you deduct $2,000 in charitable contributions, you’ll lower your taxes by $440 ($2000*.22).
That’s not bad, but here’s why tax credits are better: Any tax credit you can claim reduces your taxes on a dollar-for-dollar basis, up to the limit of the credit. A financial advisor can help you build a financial plan that optimizes your tax strategy and capitalizes on available tax credits.
Tax Credits in Action
Let’s say that instead of charitable contributions, you made your home more energy efficient by installing a heat pump. This allows you to claim a $2,000 tax credit, which reduces your tax bill by the full $2,000.
Tax professionals explain that the difference between tax deductions and credits is that credits are “above the line” – meaning that they’re listed before the crucial calculation of your adjusted gross income on Line 11 of IRS Form 1040. That means they reduce your taxable income by the full amount of the credit. Any additional deductions listed further down your tax form are “below the line,” and reduce your taxes only by the amount of the deduction multiplied by your marginal tax rate. The highest marginal federal tax rate is currently 37%.
And here’s the very best part: some tax credits are partly or fully refundable. That means, if your tax credits are worth more than your tax bill, the difference will be refunded to you in cash. If you’re lucky, deductions might get your tax liability down to $0 but any additional write-off won’t be refunded. A financial advisor with tax expertise can help you better understand what deductions and credits you may be eligible for.
What Tax Credits Are Available?
Tax credits (and deductions) are listed on the IRS website, and broken down into several categories. Here’s a look at a combination of individual credits, family, dependent and education credits, as well as clean energy credits:
Child Tax Credit
The Child Tax Credit is worth up to $2,000 per child, with up to $1,600 refundable for 2023. To qualify, the child must have a Social Security number, be 17 or younger, be claimed as a dependent. Your annual income also must be less than $200,000 for single filers or $400,000 for joint returns.
Child and Dependent Care Tax Credit
This is a complicated credit for a spouse, child or another individual who could be claimed as a dependent, lived with you for more than half the year and is physically or mentally incapable of taking care of themselves.
Excess Social Security Tax Credit
This applies if you had too much Social Security tax withheld by your employer, which can happen if you worked for two or more employers during the year. If you earned more than the Social Security payroll tax cap of $160,200 in 2023 ($168,600 in 2024), and paid the 6.2% Social Security tax on earnings above that limit, you may be eligible for a refund via a tax credit. (This also applies to railroad retirement tax, as well.)
Adoption Tax Credit
For families that finalized the adoption of a child during 2023, the credit is $15,950 per adopted child. This credit is non-refundable.
Foreign Tax Credit
If you have foreign earned income or investments in your portfolio that already were subject to overseas taxes, you can claim this credit to avoid being taxed twice on the same income. This is a complicated credit and only foreign income taxes paid qualify. For example, if you worked in France, your French Generalized Social Contribution Taxes aren’t considered income tax by the IRS and don’t count toward this credit.
Education Tax Credits
Both the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC) apply to children and dependents to “defray the cost of higher education expenses for tuition, certain fees and course materials for four years.”
The AOTC, which is refundable for students earning a degree or credential, covers required educational expenses, including necessities like books, supplies and equipment. The credit is worth up to $2,500 per student (total $10,000 over four years) and is also 40% refundable. The LLC is worth 20% of up to $10,000 of educational expenses ($2,000). However, this credit isn’t refundable, has no lifetime limit and doesn’t require the student to be pursuing a degree.
Both these credits start phasing out for taxpayers with modified adjusted gross income (MAGI) of $80,000 for single filers ($160,000 joint) and aren’t available to taxpayers with MAGI of $90,000 or more ($180,000 joint).
Residential Energy/EV Credits
To promote energy efficiency, the IRS gives a credit of up to $3,200 for “qualified energy-efficient improvements to your home” during 2023, including energy efficiency improvements, residential energy property expenses (certain types of water heaters, heat pumps, boilers, windows, doors and more) and home energy audits, under the nonrefundable Residential Energy Credit.
The non-refundable Clean Vehicle Credit covers a qualifying new “plug-in electric vehicle (EV) or fuel cell vehicle (FCV)” purchased in 2023. The credit is worth between $2,500 and $7,500 depending on the specific vehicle. If you purchased the vehicle after April 18, additional criteria apply to getting the credit. The vehicle must be new and the suggested retail price can’t be more than $80,000 for vans, sport utility vehicles and pickup trucks or $55,000 for other vehicles. You can see if your vehicle qualifies at fueleconomy.gov. However, claiming either of these credits is complicated.
Bottom Line
Tax credits offer the potential for significant, dollar-for-dollar savings on your federal income taxes. Some can be complex but it’s well worth your while to make the effort to properly claim them.
Tax Planning Tips
- A number of provisions of the Tax Cuts and Jobs Act of 2017 are set to expire at the end of 2024, meaning you could see your tax bracket change and tax liability increase. The standard deduction is also due to revert to its pre-TCJA level (adjusted for inflation). That’s why it’s important to stay ahead of the game and prepare for these changes, whether you’re a high earner or not.
- A financial advisor with tax expertise can potentially help you capitalize on certain tax credits. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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