Tax Credits 101: Saving Money On Taxes

Tired of having to pay big taxes every year?

Do you want to save some money and pay your taxes at the same time?

If so, you've come to the right place. Tax credits are a strong way to lower your tax bill and keep more of your own money. I'll go into detail about tax credits in this piece, explaining what they are, how they work, and how you can use them to your advantage. We can help you with everything from popular tax credits for individuals to using tax credits to pay self-employment taxes. Grab a cup of coffee, take a seat, and let's learn about tax credits together!

Key Takeaways

  • Tax credits directly reduce tax owed, while deductions only reduce taxable income. There are three types of tax credits: nonrefundable, refundable, and partially refundable.
  • Common tax credits for individuals include the American Opportunity Tax Credit, Saver's Credit, and Earned Income Tax Credit.
  • Unused tax credits can be carried forward for up to 20 years, but there are income limits for claiming tax credits.
  • To claim tax credits, determine which credits you qualify for, fill out the appropriate forms, and attach them to your tax return.
  • Self-employed individuals can deduct the employer portion of their self-employment tax from their taxable income using the Self-Employment Tax Deduction.
  • Increasing contributions to retirement accounts can reduce taxable income and result in tax savings.

Understanding Tax Credits

What are Tax Credits?

Tax credits are a type of reward that lower a person's or business's income tax bill. Tax benefits directly reduce the amount of tax you owe, unlike tax deductions, which reduce the amount of income that is taxed.

For example, if you owe $1,000 in taxes and are qualified for a $1,000 tax credit, your net liability drops to $0.

Types of Tax Credits

There are three types of tax credits: ones that can't be refunded, ones that can, and ones that can only be partly refunded.

  • Nonrefundable tax credits reduce the amount of income tax owed but cannot reduce it below zero.
  • Refundable tax credits can reduce the amount of income tax owed below zero and result in a refund.
  • Partially refundable tax credits can reduce the amount of income tax owed below zero but only up to a certain amount.

There are many different kinds of tax credits, such as tax credits for saving energy, tax credits for schooling, and tax credits for saving for retirement.

  • Energy efficiency tax credits are provided by the federal government to encourage Americans to make homes and buildings more energy-efficient.
  • Education tax credits are available to individuals who pay for higher education expenses, such as tuition and fees.
  • Retirement savings contributions tax credits are available to eligible individuals who contribute to their IRA or employer-sponsored retirement plan.

How Tax Credits Differ from Tax Deductions

Tax deductions make it so that less of your pay is taxed. Your deductions lower your taxable income by the percentage of your highest federal income tax rate. For instance, if you pay 22% of your income in taxes, a $1,000 reduction saves you $220. Standard or itemized deductions are both possible. You can either take the standard deduction or write off specific expenses, but you can't do both.

On the other hand, tax credits lower the amount of tax you have to pay. Most of the time, tax credits are better than tax deductions because they cut your tax bill by the same amount as the credit. But deductions can still be helpful and can help lower the amount of your income that is taxed.

Qualifying for Tax Credits

The IRS tells you what you need to do to get both nonrefundable and refundable tax credits. A tax expert can help you figure out if you should claim a credit, a deduction, or both, if you are qualified.

Common Tax Credits for Individuals

American Opportunity Tax Credit (AOC)

People who are going to college can take advantage of the American Opportunity Tax Credit (AOC). The AOC lets people claim up to $2,000 in school fees, tuition, books, and tools, plus 25% of the next $2,000 spent on these things.

This credit can be used during the first four years of college.

Saver's Credit

The Saver's Credit is a tax credit for people who put money into a retirement account like an IRA or 401(k). It is also called the Retirement Savings Contributions Credit. Depending on how much money you make, the credit is between 10% and 50% of the first $2,000. This credit is offered to people who make up to $32,500 if they file as a single person or $65,000 if they file as a married couple.

Earned Income Tax Credit (EITC)

The Earned Income Tax Credit (EITC) is a refundable tax credit for people and families with low to moderate incomes who work or are self-employed and make money. The amount of the credit depends on your income, your filing status, and the number of people who count on you.

This credit is offered to people who earn up to $56,844 if they are married and file their taxes as a couple and have three or more qualifying children.

Other Tax Credits

There are also the Child and Dependent Care Credit, the Lifetime Learning Credit, and the Residential Energy Credit that can be used by people. Tax credits have specific requirements for who can get them, so people should talk to a tax expert or use tax software to find out which credits they qualified for and how to claim them.

Refundable versus Nonrefundable Tax Credits

Some tax credits are not refundable, which means that if you don't owe much in taxes to start with, and the credits bring your tax bill down to zero, you don't get the full value. For example, you won't get a $400 tax return check if you have a $600 tax bill and a $1,000 credit that you can't get back.

But some tax credits, like the earned income tax credit or the child tax credit, are refundable.

If you are eligible for refundable tax credits, the value of the credit can be more than the amount of tax you owe.

This means that even if you don't owe any tax, you could get a tax return.

Carrying Forward and Income Limits

It's important to know the difference between tax credits and tax reductions when it comes to taxes. Tax credits reduce the amount of income tax owed dollar for dollar, while tax deductions reduce a person's tax obligations by lowering their taxable income.

But did you know that tax credits can be moved forward or back, but tax deductions can't? Let's look at the specifics.

Carrying Forward Tax Credits

Tax credits that were not used can be rolled forward for up to 20 years and used to pay taxes in those years. This "carry-forward" function is important for keeping cash flow going when money is tight.

Tax credits that can be refunded, like the Earned Income Tax Credit (EITC), can also be moved forward or backward.

If there is any money left over from a refundable credit after the tax debt is reduced to zero, the taxpayer can get the rest of the credit back as a refund.

Income Limits for Tax Credits

Yes, there are limits to how much money you can make and still get tax credits. Depending on the type of tax credit, the limits on how much you can make change. For example, married couples filing jointly with incomes of up to $68,000 in 2022 or $73,000 in 2023 can claim the Saver's Credit.

Heads of family with incomes of up to $51,000 in 2022 or $54,750 in 2023 can also claim the credit.

On the other hand, the amount of the Child Tax Credit goes down if your modified adjusted gross income is more than $400,000 (if you're married and filing jointly) or $200,000 (if you're not married and filing separately).

Child and Dependent Care Tax Credit

The Child and Dependent Care Tax Credit does get smaller as income goes up, but there is no cap on how much you can make and still get the credit, except in 2021. For the tax year 2022, the most you can claim for care costs for one person is $3,000, and the most you can claim for two or more people is $6,000. You can claim anywhere between 20% and 35% of your qualified costs.

It's important to remember that the limits on income and other requirements for tax credits can change from year to year, so it's important to check with the IRS or a tax professional for the most up-to-date information.

Claiming Tax Credits

With tax credits, you can save a lot of money on your taxes. They cut the amount of income tax you owe by $1 for every $1 you get back. There are three kinds of tax credits: those that are not refundable, those that are refundable, and those that are partly refundable.

Types of Tax Credits

Nonrefundable tax credits can lower your tax bill to zero, but you don't get any extra money back if you have more credits than you need. Tax credits that can be returned can lower your tax bill to below zero, and any extra credit is given back to you.

Partially refundable tax credits are a mix of tax credits that cannot be refunded and tax credits that can be refunded.

Qualifying for Tax Credits

You need to find out if you are eligible for any tax credits before you can claim them on your tax return. The Earned Income Tax Credit (EITC), the Child Tax Credit, and the American Opportunity Tax Credit are all tax credits that people often use.

Once you know which tax credits you are eligible for, you need to fill out the right forms and send them with your tax return.

The forms will ask for things like your income, expenses, and the number of people who count on you.

For some points, you may also need to show proof to back up your claim.

Tax Credits versus Tax Deductions

It's important to remember that tax credits and tax refunds are not the same thing. Tax deductions lower the amount of your income that is taxed, while tax benefits lower the amount of tax you have to pay.

It's a good idea to use both tax credits and tax benefits to save the most money on your taxes.

Tips for Saving Money on Your Taxes

You can save money at tax time by saving some of your tax return in advance. You can also save for taxes all year long in a different account. You can also file your taxes online and use direct deposit to get your money back faster without having to pay a fee.

Tax Credits for Small Business Owners

Small business owners can get tax credits, which is true. Tax credits for small businesses can directly lower a company's tax bill. The Credit for Small-Business Health Insurance Premiums, the Employee Retention Credit, and the Paid Leave Credit are some of the most important small business tax credits that are available right now.

Small business owners can also deduct qualified health insurance premiums and business costs like travel, marketing, insurance, and more.

The Employee Retention Credit and Paid Leave Credit are two of the most important tax breaks that the American Rescue Plan gives to small businesses. The Employee Retention Credit lets businesses take up to $7,000 per employee per quarter off their regular payroll tax bills. The most you can get from the Paid Leave Credit is $200 per day, up to a total of $10,000. Businesses that paid workers through these programs between April 1, 2020 and December 31, 2020 can use the tax credit to lower their payroll taxes.

Small business owners should also know about tax credits like the research and development (R&D) tax credit that they might not know about. The owner of a business can get both credits and discounts as long as they meet the requirements.

It's always a good idea to talk to a trusted tax professional about tax credits to make sure you're taking advantage of all the ones you can.

Tax Deductions: The Hidden Gems of Saving Money

When it comes to saving money, tax deductions are often overlooked. But did you know that they can significantly reduce your taxable income and ultimately lower your tax bill? Tax deductions are expenses that you can subtract from your income before calculating your taxes.

This means that the more deductions you have, the less you'll owe in taxes.

There are many types of tax deductions available, including those for charitable donations, mortgage interest, and medical expenses.

You can also deduct expenses related to your job, such as travel and education costs.

However, it's important to note that not all deductions are created equal.

Some have limits or require you to meet certain criteria.

To take advantage of tax deductions, you'll need to itemize your deductions on your tax return instead of taking the standard deduction.

This may require more effort, but it can be worth it in the long run.

So, don't forget to explore the world of tax deductions and see how they can help you save money.

For more information:

Maximize Savings: Tax Deductions 101

Using Tax Credits for Self-Employment Taxes

Understanding Self-Employment Tax

Before we talk about tax credits, let's talk about self-employment tax. Self-employment tax is a mix of the taxes that self-employed people pay for Medicare and Social Security. At the moment, the tax rate for people who work for themselves is 15.3%.

Of that, 12.4% goes to Social Security and 2.9% goes to Medicare.

Deducting Self-Employment Tax

One way to lower the taxes you have to pay as a self-employed person is to claim them as business expenses. This is one of the most popular tax breaks for people who work for themselves. But it's important to remember that when you deduct half of the self-employment tax, it only lowers your taxable income for income tax reasons.

It doesn't lower your net earnings from self-employment or the self-employment tax.

Using Tax Credits for Self-Employment Taxes

Tax credits are different from tax exemptions in that they directly lower the amount of tax that needs to be paid. People who work for themselves can get tax breaks like the Earned Income Tax Credit and the Child and Dependent Care Credit.

But you can't use these tax credits to pay for your own self-employment taxes.

The Self-Employment Tax Deduction

The Self-Employment Tax Deduction is a tax credit that people who work for themselves can get. With this deduction, you can take the 7.65% of your self-employment tax that goes to Social Security and Medicare that goes to the boss out of your taxable income.

You can save a lot of money on your income taxes if you use this deduction.

Other Tax Credits for Self-Employed Individuals

Even though the Self-Employment Tax Deduction is the only tax credit for self-employment taxes, you may be able to get other tax credits if you work for yourself. For example, if you have children, you might be able to get the Child Tax Credit or the Additional Child Tax Credit.

The Earned salary Tax Credit might be for you if you have a low salary.

These tax credits can help you pay less in taxes total, giving you more money to spend on your business.

Maximizing Tax Savings

1. Increase Retirement Account Contributions

Putting more money into your retirement account is one of the easier ways to lower your taxable income. Most payments to a traditional IRA, 401(k), or 403(b) are made with money that has already been taxed.

This means that putting more money into either can save you money on taxes by lowering your taxable income.

For example, you can lower your taxable income by $5,000 if you put $5,000 into a standard IRA.

2. Invest in Tax-Efficient Index Mutual Funds and ETFs

Investing in index mutual funds and exchange-traded funds (ETFs) that are tax-efficient is another way to get the most out of your tax saves. These kinds of funds are made to help you pay as little tax as possible on your assets.

They do this by reducing the number of times your stock changes hands.

This lowers the amount of capital gains tax you have to pay.

3. Consider Cash-Value Life Insurance

High-income earners should have a plan for diversifying their interests and think about cash-value life insurance, which is one of the most popular ways for high-income earners to put off paying taxes because the limits on how much can be invested are higher.

Cash-value life insurance plans let you build up a cash value over time, which can be used to pay for future premiums or taken out tax-free.

4. Take Advantage of Tax Credits

Most of the time, tax credits are a better way to get a bigger return than deductions because they reduce your taxes dollar for dollar. Tax credits for making changes to your home that save energy can also help you keep more money in your pocket all year and when it's time to pay your taxes.

For example, if you put solar panels on your home, you might be able to get a tax credit worth up to 26% of the cost of the panels.

5. Look for Clean Energy Tax Credits

When it was signed into law in August 2022, the government Inflation Reduction Act set aside nearly $400 billion for clean energy tax credits and other measures to fight climate change. For people, tax credits that could be worth thousands of dollars for buying new or used energy-efficient cars may be the most important thing to think about.

If you want to get a new car and take advantage of these tax breaks, you should think about getting an electric or hybrid car.

Note: Please keep in mind that the estimate in this article is based on information available when it was written. It's just for informational purposes and shouldn't be taken as a promise of how much things will cost.

Prices and fees can change because of things like market changes, changes in regional costs, inflation, and other unforeseen circumstances.

Concluding thoughts and considerations

In the end, tax credits can help you save money on your taxes. If you know about the different types of tax credits, you can use them to your advantage and save as much money as possible. But it's important to remember that you may not be able to get certain credits if your income is too high or if you don't meet other requirements.

Also, if you work for yourself, you may be able to lower your self-employment taxes with tax credits.

But here's something to think about: tax credits can help you save money, but they shouldn't be the only reason you decide to do something.

For example, if the tax credit is the only reason you want to buy a new car, you should also think about how much the car will cost you total and if it will meet your needs.

At the end of the day, tax credits are only one part of figuring out how to handle your money.

You can save money on your taxes and reach your long-term financial goals if you stay aware and make smart choices.

So go ahead and use those tax credits, but don't forget to think about the bigger picture.

Your Freedom Plan

Tired of the daily grind? Do you have dreams of financial independence and freedom? Do you want to retire early to enjoy the things you love?

Are you ready to make your "Freedom Plan" and escape the rat race?

Future Freedom Plan

How Much of Your Paycheck Should You Save? (With Data)

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Links and references

  1. "2022 Publication 17" by the Internal Revenue Service (IRS)
  2. "Taxpayer's Guide" by the Michigan Legislature
  3. "Compliance Online Reference Manual" by the State Treasurer's Office in California
  4. "Glossary of Tax Terms" by the Organisation for Economic Co-operation and Development (OECD)
  5. "HPD-LIHTC-Compliance-Manual" by the New York City Department of Housing Preservation and Development

My article on the topic:

Tax Implications 101: Saving Money & Avoiding Mistakes

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