A critical area of personal finance for everyone to understand is the availability of tax credits. A tax credit is an amount of money a taxpayer can deduct, dollar-for-dollar, against their tax liability for the year. Tax credits can be more beneficial than tax deductions because a tax credit is a direct reduction in one’s tax liability. Whereas a tax deduction simply reduces the amount of one’s taxable income which results in a smaller reduction in the final tax liability.
For example, a taxpayer in a 24% tax bracket who is allowed a $1,000 deduction saves $240 in taxes (24% x $1,000 = $240). A taxpayer who is allowed a $1,000 tax credit actually saves the full $1,000 in taxes. The same individual in a 24% tax bracket requires a tax deduction of $4,166.66 to create the same tax savings of $1,000 ($4,166.66 X 24% = $1,000). As you can see a tax credit is much more beneficial than a tax deduction. What’s more, the lower your tax bracket the less valuable a tax deduction is. An individual in the 12% tax bracket would need a tax deduction of $8,333.33 just to equal the same amount as a $1,000 tax credit!
Tax credits are classified as either nonrefundable or refundable. The big difference is that refundable tax credits can pay you back beyond your original tax liability which results in a tax refund. Nonrefundable tax credits can only offset your tax liability up to the amount of the liability and anything extra is lost. For example, if you had a $1,000 tax liability for the year and a $2,000 refundable tax credit you would receive a $1,000 tax refund check. If instead the $2,000 tax credit was a nonrefundable credit it would only bring your tax liability to $0 and you would not receive a tax return check of $1,000 since the remainder is lost.
Several common tax credits include:
The credit for other dependents is for individuals who cannot be claimed for the Child Tax Credit but meet dependency requirements (typically a child age 17 or older or a dependent parent). This is a non-refundable tax credit of up to $500 per qualifying person. The qualifying dependent must be a U.S. citizen, U.S. national, or U.S. resident alien.
Income tax calculating software and services do a great job of determining which tax credits may be available, but it’s important for financial planners and advisors to stay informed about available credits given a client’s personal circumstances. The more you know the more you can help your clients!