Introduction to U.S. Individual Taxation Deductions and Credits III
In the individual income tax system, tax credits and deductions form the two primary tools for taxpayers to optimize their tax liabilities. While the "deduction" introduced in prior articles indirectly reduce tax obligations by decreasing the taxable income base (Adjusted Gross Income or taxable income), "tax credits" achieve tax relief more directly by offsetting tax liabilities through statutory percentages or fixed amounts.
Based on their attributes, credits are categorized into "nonrefundable credits" (which are designed to reduce an individual’s tax liability to zero but cannot generate a cash refund, comprise the child and dependent care expenses credit, the credit for the elderly or disabled, education credits) and "refundable credits" (which are deducted from income tax liability, may generate a cash refund when the credit exceeds the tax owed—even if no tax was withheld from wages, comprise the the Premium tax credit, child tax credit, earned income tax credit). Following this, this article will provide a brief introduction to nonrefundable tax credit programs, including education credits, and the elderly or disabled credit.
-
Credit for Child and Dependent Care Expenses
The credit may reach up to 35% of qualified expenses. The expenditure cap is $3,000 for one dependent and $6,000 for two or more dependents.
(1)
|
Eligible people
The Child and Dependent Care Credit applies to taxpayers who keep a household, are employed, and bear qualifying expenses for the care of the following qualified individuals:
(a) A qualifying dependent child who is younger than 13 years old at the time care is provided.
(b) Any disabled dependent of any age who lacks the capacity to care for themselves regardless of whether they qualify as a dependent, provided the taxpayer satisfies the dependent support test (i.e., furnishes at least half of their support).
(c) A spouse who is incapacitated and unable to care for themselves.
|
(2)
|
Earned (work) income requirement
Married taxpayers must both generate earned income from wages, salary, or net self-employment earnings to be qualified for the childcare credit (except when one is a full-time student or physically or mentally disabled). The credit is calculated by taking the minimum of:
(a) the earned income of the spouse with lower earnings,
(b) the actual childcare expenses incurred, or
(c) the expenditure cap (i.e., $3,000 for one child or $6,000 for two or more).
This minimum amount is then multiplied by the relevant percentage (not exceeding 35%).
|
(3)
|
Eligible expenses
Qualified expenses must serve the purpose of enabling the taxpayer to engage in gainful employment (i.e., permitting them to work or seek employment). Examples include babysitting services, nursery school, and day care—but exclude elementary school.
|
(4)
|
Credit calculation (income thresholds are not adjusted for inflation)
(a) The credit rate varies between 20% and 35% of permissible employment-related costs, determined by adjusted gross income.
(b) Taxpayers with adjusted gross income exceeding $43,000 qualify for a credit equal to 20% of permissible employment-related costs.
(c) Taxpayers with adjusted gross income of $15,000 or less qualify for a credit equal to 35% of permissible employment-related costs.
(d) For adjusted gross income ranging from $15,001 to $43,000, the allowable credit percentage slides from 20% to 35%.
|
-
Credit for Elderly or the Disabled
This 15% tax credit on "qualified income" applies to individuals who are at least 65 years old; or those under 65 but retired due to permanent disability.
(1)
|
Base amount (not indexed for inflation)
The base amount used to figure the credit is as follows:
(a) $5,000 for a single person, widow, or widower;
(b) $5,000 if married filing jointly and only one spouse is a qualified individual;
(c) $7,500 if married filing jointly and both are qualified individuals; or
(d) $3,750 for a qualified individual who is married filing separately.
For an eligible individual under 65 years old with disability income of less than $5,000, the base amount is capped at $5,000.
|
(2)
|
Eligible income
A taxpayer's "qualified income" is calculated as the base amount deducted by:
(a) any Social Security payments and other excludable pensions or annuities received by the taxpayer; and
(b) 50% of the taxpayer's adjusted gross income that surpasses the following thresholds:
(i) $7,500 for single filers
(ii) $10,000 for married couples filing jointly
(iii) $5,000 for married individuals filing separately
|
(3)
|
Credit calculation
A taxpayer who is 65 or older is entitled to the Tax Credit for the Elderly and the Disabled, which begins with a designated amount that is diminished by any Social Security benefits and other non-taxable pensions, as well as by 50% of any adjusted gross income exceeding the specified threshold. The resulting amount, if applicable, is multiplied by 15% to compute the allowable tax credit.
|
-
Education Tax Incentives
Provided that eligibility criteria are satisfied, a taxpayer may use the American Opportunity Tax Credit, Lifetime Learning Credit, and/or a tax-free withdrawal from a Coverdell Education Savings Account (allocated for post-secondary educational expenses) to alleviate the costs of higher education.
(1)
|
The American opportunity tax credit ($2,500 maximum)
The American Opportunity Tax Credit (AOTC) applies toward federal income tax liabilities for eligible tuition, educational expenses, and instructional materials (such as textbooks) incurred for a student’s initial four years of higher education at an accredited educational establishment.
-
The credit amount consists of a maximum allowable credit of $2,500: 100% of the first $2,000 in eligible expenses, plus 25% of the subsequent $2,000 paid during the tax year. Under specified limitations, 40% of the American Opportunity Tax Credit (AOTC) is refundable—the nonrefundable portion may reduce both regular and alternative minimum tax liabilities. This allows for a refund of up to $1,000 (calculated as 40% of the $2,500 maximum credit).
-
Eligible expenses are determined on a per-student basis and must be paid for the taxpayer, their spouse, or dependents. If a child is claimed as a dependent by a parent, expenses covered by both the parent and the child are considered paid by the parent for credit purposes. The student must be enrolled on at least a half-time basis for at least one academic term during the tax year. This credit is unavailable for students who have been found guilty of a federal or state felony drug crime (in the current or prior years).
-
The credit begins to phase out when modified AGI exceeds $80,000 ($160,000 for joint filers), with complete phase-out occurring at modified AGI above $90,000 ($180,000 on joint returns). These thresholds are not adjusted for inflation.
|
(2)
|
The lifetime learning credit ($2,000 maximum per year)
The lifetime learning credit (LLC) is available for an unlimited number of years for qualified tuition and related expenses (but not books unless required to be purchased through the school) at an eligible educational institution.
-
The credit amounts to 20% of eligible expenses up to a maximum of $10,000. Eligible expenses comprise tuition costs and educational fees for undergraduate-level courses, graduate-level programs, specific professional degree courses, and courses designed to develop or enhance vocational skills. These expenses are calculated on a per-taxpayer basis (with married filing jointly treated as a single taxpayer), as opposed to a per-student basis, meaning the maximum credit remains $2,000 irrespective of the number of qualifying students.
-
Similar to the American Opportunity Tax Credit, costs incurred by a dependent child are deemed to be paid by the parent for tax credit purposes.
Taxpayers are not required to opt for a single type of credit on their annual tax return. For instance, a parent may claim the Lifetime Learning Credit for one child’s educational expenses and the American Opportunity Tax Credit for another child’s expenses within the same tax year.
|
(3)
|
Coverdell education savings accounts
An additional type of education savings account exists, established to cover eligible educational costs for a specified beneficiary. Contributions to these accounts are not tax-deductible, with annual contribution limits set at $2,000 per beneficiary. Earnings within the account accumulate tax-free, and both principal and interest withdrawals are tax-exempt when used for the designated beneficiary’s qualified education expenses—including costs for eligible elementary and secondary schooling.
|
-
Retirement Savings Contribution Credit (Saver's Credit)
A nonrefundable tax credit that may reduce both regular and alternative minimum tax liabilities applies to contributions made to traditional IRAs, Roth IRAs, 401(k) plans, SIMPLE IRAs (for self-employed individuals), and certain other eligible retirement plans. For tax years 2018 through 2025, beneficiaries of an Achieving a Better Life Experience Plan (ABLE) can claim the Saver's Credit for contributions to their ABLE accounts—this credit is inapplicable to non-beneficiary contributors who are not the ABLE account holders themselves.
Qualified taxpayers must be aged 18 or older by the end of the tax year, not enrolled as full-time students, and not claimed as dependents by another taxpayer. Additionally, the credit is capped at the individual’s tax liability as determined by the Form 8880 Credit Limit Worksheet. Unused credits cannot be carried over to subsequent years.
-
Foreign Tax Credit
Taxpayers may claim a credit for foreign income taxes paid to a foreign country or U.S. possession, with a cap on the credit amount available to individuals. Alternatively, instead of claiming this credit, individuals may deduct the foreign taxes paid as an itemized deduction.
If an itemized deduction is elected, there is no limit on the amount of foreign tax deducted; however, foreign tax credits (FTC) are capped at the lesser of foreign taxes paid or the product of (taxable income from all foreign operations ÷ worldwide taxable income) and U.S. tax (before FTC)—this is the FTC limit. Any disallowed FTC may be carried back one year and forward 10 years. For further details, refer to the prior article:
https://www.kaizencpa.com/Knowledge/info/id/1772.html
-
General Business Credit
The general business credit encompasses multiple credits, including the investment credit, work opportunity credit, increased research credit (typically 20% of the increase in qualified research expenditures above the annual base amount), low-income housing credit, employer-provided childcare credit, paid family and medical leave credit, energy credits, and other less common credits.
The credit may not exceed the "net income tax" (regular income tax plus alternative minimum tax, minus nonrefundable tax credits excluding the alternative minimum tax credit) minus the greater of 25% of regular tax liability exceeding $25,000 or the "tentative minimum tax" for the year. Any disallowed general business credit may be carried back one year and forward 20 years.
Reference:
https://www.irs.gov/pub/irspdf/f1040s1.pdf
https://www.irs.gov/pub/irs-pdf/p529.pdf
https://www.irs.gov/pub/irs-pdf/p590a.pdf
https://www.irs.gov/pub/irs-drop/n-23-75.pdf
https://www.irs.gov/pub/irs-pdf/i3903.pdf
https://www.irs.gov/pub/irs-pdf/p550.pdf
KNOWLEDGE
