Tax Credits for All
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.
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 2004 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 54.
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 2004. 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 46. 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 2004 and earned over $87,900 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 66. (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 2004, 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 47. 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 51.
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 2004, both breaks are phased out between AGI of $85,000 and $105,000 for joint filers ($42,000 and $52,000 for singles). Say your 2004 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 $214,050 and $336,550 for joint filers ($142,700 and $265,200 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 2004 tax bill. Whoever claims the credit must fill out Form 8863. The credit is then reported on Form 1040, Line 49.
If you adopt an under-age 18 child, you may qualify for a tax credit of up to $10,390 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 $155,860 and $195,860. If you qualify, claim the credit by filing Form 8839 (Qualified Adoption Expenses) with your 1040. Enter the credit amount on Line 52.
This tax break potentially applies to individuals who: (1) were at least age 65 at the end of 2004 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 48.