“Wealth is the ability to fully experience life.” – Henry David Thoreau
If you’re like a lot of taxpayers, you probably hear “tax credits” and think, free money!
And you would be right… at least mostly.
But tax credits are really much more nuanced than that. And understanding those nuances could be what saves you from getting a smaller-than-expected refund, or finding out you actually owe the IRS.
So, what are the different types of credits that concern you?
Nonrefundable tax credits: use it or lose it. A nonrefundable tax credit reduces the amount of tax you owe, but if your tax bill is already zero, it does nothing for you. The value is cut off at your income tax liability. For example, let’s say you owe 1.5K in taxes, but you qualify for a 2K Lifetime Learning Credit. You’ll only get a 1.5K deduction – and you’ll never see that extra 500 dollars.
Most tax credits fall into this category, like the Saver’s Credit, the Foreign Tax Credit, and the Child and Dependent Care Credit.
Refundable tax credits: payday from Uncle Sam. If the credit exceeds what you owe, the IRS refunds you for the difference. Let’s say, for instance, you owe 1.5K in taxes but you qualify for the Earned Income Tax Credit (EITC) worth 3.5K. The IRS would then wipe out your tax bill and send you a 2K refund.
Credits in this category that you might qualify for include the EITC, the Additional Child Tax Credit (ACTC), and the Premium Tax Credit.
Partially refundable tax credits: the third wheel. Some credits split the difference – part reduces your tax bill, and part is refundable if you don’t owe taxes. The Child Tax Credit is a good example of this. It’s worth up to 2K per child, but only 1.6K of it is refundable. It will reduce what you owe first, and you’ll receive anything remaining as a refund.
Another popular fence-sitter is the American Opportunity Tax Credit (AOTC), which is 40 percent refundable up to 1K.
Which one’s better?
Like most things when it comes to your taxes, it depends. Refundable credits might be a better option for you if you’re lower-income, because you can get a refund even if you don’t owe taxes.
If you’re a higher-income filer, on the other hand, you could see greater benefits from nonrefundable credits. You likely owe taxes, and you can use these credits to lower your bill. The Savers Credit has income limits you’ll need to be within, but the other nonrefundable credits I listed don’t impose income limits.
Or, you can go for both if you qualify. Just make sure to apply refundable credits last so you maximize their impact.
How to be credit smart
To make sure you’re taking full advantage of the credits available to you, here’s what you’ll need to do:
- Do a comprehensive financial review. Review your income and expenses, and estimate your tax liability so you know whether to adjust your withholding or quarterly tax payments. And think about any life changes that would affect your credit eligibility.
- Understand your credit eligibility. Check that you don’t exceed income thresholds for the credits you want to claim. Also, check that your filing status is optimized – married filing jointly typically gets you the most credits, and filing as head of household if you’re single could get you lower tax rates and higher EITC income thresholds. If you’re in school, see if you qualify for the AOTC or Lifetime Learning Credit.
- Plan for credit phaseouts. Try to reduce your taxable income to stay within income thresholds. For example, if you land just above a phaseout range, consider deferring income, increasing 401(k) contributions, or making deductible IRA contributions.
- Strategically apply your credits. Use nonrefundable credits first to lower your tax bill, then apply refundable credits to get the highest refund possible. If a credit phases out next year, take action on claiming it now.
- Keep good records. Save things like your W-2s, 1099s, tuition statements (1098-T), receipts, tax documents, and childcare expense records. Because if you’re claiming credits like the EITC or education credits, the IRS is going to ask for documentation (and they can audit you if you don’t have it).
And if you’re now realizing you missed a credit and you’ve already filed, you can still snag it. You have up to three years after filing to amend your return with Form 1040-X.
It’s worth looking back to see if you left money on the table in past years, even if you don’t remember doing so. A lot of my clients have missed the EITC or ACTC in years past because they didn’t realize they qualified.
I know we’ve trekked deep into the swamps of tax technicalities here, but this really will make a difference on your tax return this year (and years to come). Because being credit-savvy will ultimately help you keep more money in your pocket – which is what my team and I are all about.
So, if you want help figuring out your best credit strategy (and making sure you don’t miss any) this tax season, get your documents in if you have not already, or take your time and go on extension. We have plenty of time to talk about these in the off-season.