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Why you can't afford to overlook tax credits

Deductions and credits can both lower your tax bill, but according to the Maryland Association of CPAs, they are by no means created equal. Tax credits are more valuable than deductions in cutting your bill.

Understanding the tax difference

Whether you itemize or take the standard deduction, tax deductions are used in calculating your taxable income. Deductions reduce your tax bill by lowering your taxable income. The amount you save from deductions depends on your marginal tax bracket. The higher your tax bracket, the more you can save. Tax credits, on the other hand, apply after you have determined your tax liability and cut your tax bill dollar-for-dollar.

Here's an example: For someone in the 25 percent tax bracket, a $1,000 deduction reduces the tax bill by $250. By contrast, a $1,000 tax credit reduces the taxpayer's bill, dollar-for-dollar, by $1,000. So if you owe the IRS $2,000, a $1,000 credit cuts your bill in half.

Some common tax credits

The most common credits are child- and education-related; many have age implications.

• The child tax credit for 2004 is $1,000 for each qualifying child. Your child must be younger than 17 at the end of the calendar year and claimed as a dependent on your return.
• The adoption credit for 2004 is $10,390 per qualifying child.
• The Credit for the Elderly or Disabled is available to individuals who are either 65 or older or are younger than 65 and retired on permanent and total disability.
• The child and dependent care credit amounts to between 20 and 35 percent of qualifying expenses. The credit is available to parents who, in order to work, pay someone to care for a dependent child under 13 or for a relative who is incapable of self-care. For 2004, you can apply the credit percentage toward $3,000 of the care for one dependent and $6,000 for two or more.
• The Hope Scholarship Credit provides a credit of up to $1,500 per student during each of the first two years of college. The credit applies only to tuition and related fees. The student must be enrolled at least half-time.
• The Lifetime Learning Credit applies to tuition costs for undergraduate- and graduate-level courses and also to courses for improving job skills. The credit is equal to 20 percent of your eligible Lifetime Learning expenses, for a maximum $2,000 credit.
• The Earned Income Credit helps reduce the tax burden on lower-income taxpayers. This year, the maximum credit is $2,604 for persons with one qualifying child, $4,300 for persons with two or more qualifying children, and $390 for persons without a qualifying child.

Special rules apply

Many tax credits are reduced or eliminated for higher income taxpayers. In some cases, the credits cannot be claimed simultaneously. For example, you cannot take the Hope Credit and the Lifetime Learning Credit for the same student in the same year.

Some credits require that you itemize your deductions and some exclude taxpayers who are married and file separately.

Refundable and non-refundable credits: Know the difference

There are two types of tax credits. Non-refundable credits can reduce tax to zero but can't be used to get a refund. They include the dependent care credit, the Credit for the Elderly or Disabled, the Hope and Lifetime Learning credits, and the adoption expenses credit. In most cases, the child tax credit is non-refundable, but in certain cases it is partially refundable for lower-income families.

A refundable credit, such as the Earned Income Credit (EIC), can reduce your tax below zero and provide you with a refund. For this reason, CPAs say that individuals with zero taxable income who are eligible for the EIC should file a tax return to receive the benefits.

To find out more about these credits, contact a CPA or the IRS.

Only CPAs are equipped to address your full range of financial needs with integrity and insight. In Maryland, CPAs must pass a rigorous two-day examination, adhere to strict ethical and professional standards, and, beyond college, complete 80 hours of continuing education every two years to be certified by the state — accountants do not.

Your doctor is certified; your lawyer is certified. Make sure your accountant is a certified public accountant.

For CPA referrals in your area, contact the MACPA at (410) 296-6250 or click here.

The Maryland Association of Certified Public Accountants (MACPA) is a statewide professional association that provides leadership, information and services for its nearly 10,000 CPA members, who are employed in private practice, industry, government and education. CPAs are business and financial professionals who have passed a rigorous two-day examination in order to be licensed by the state. CPAs are committed to protecting the public interest, and must adhere to stringent ethical and professional standards and continuing professional education requirements.