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Common tax credits explained

Tax credits are popular ways to reduce your overall tax burden. Credits are dollar for dollar reductions in the amount of tax due, so it's a pretty big bang for your buck. Here are five of the most common tax credits:

Credit for child and dependent care expenses. The credit for child and dependent care expenses can be fairly significant, depending on the amount that you paid and your income level. The credit is equal to a percentage of the expenses you actually paid for child care less any reimbursements from any program or social services agency. The credit starts at 35% of expenses if your adjusted gross income is less than $15,000 and phases out to 20% of expenses if your adjusted gross income is more than $43,000. The maximum credit available is $3,000 for one qualifying child and $6,000 for two or more qualifying children.

If you have out-of-home child care at a qualifying child care center, the center must meet federal and state requirements and have a total enrollment of at least six children. To claim the credit, you report the amount paid, together with the tax ID number of the child care center, on your tax return using a federal form 2441.

If you have home child care, the rules are significantly different. The IRS requires you to treat most home child care workers as household employees (among the exemptions are part-time babysitters under the age of 18). This means the workers must be eligible to work in the U.S. (so certain foreign students and others might not qualify), and you may be responsible for payroll taxes.

The credit for child and dependent expenses is one of the more complicated credits to figure out. Phaseouts, income restrictions, and other criteria apply. Check IRS Publication 503 for more details.

Education credits. Two credits allow students to recover costs associated with getting an education: the Hope Credit and the Lifetime Learning Credit. You can only elect to use one credit per year, but not both.

The Lifetime Learning Credit allows a credit of up to $2,000 ($4,000 for students in Midwestern disaster areas) for qualified education expenses paid for all students enrolled in eligible educational institutions. Just as the name implies, there is no limit on the number of years the Lifetime Learning Credit can be claimed, and you don't need to pursue a degree in order to qualify.

The American Opportunity Credit is a new credit that modifies the existing Hope Credit for tax years 2009 and 2010. The credit, which is a maximum credit of up to $2,500 per student, is now eligible to students for four post-secondary education years instead of two; the student must be pursuing a degree. Income restrictions apply -- the full credit is available to individuals whose modified adjusted gross income is $80,000 or less or $160,000 or less for married couples filing a joint return. The credit is phased out for taxpayers with incomes above these levels.

Earned income tax credit. The Earned Income Tax Credit (EITC) is a refundable federal income tax credit for low to moderate income working individuals and families. To qualify for the credit, you must have earned income from wages or from self-employment, but your investment income cannot exceed $3,100.

You must either have a qualifying child or be between age 25 and 65 while living in the U.S. for more than half the year and not qualify as a dependent of another person. Regardless of income, taxpayers who file as married filing separately do not qualify for the EITC.

Income restrictions apply. Your adjusted gross income (AGI) must be less than:
  • $43,279 ($48,279 for married filing jointly) if you have three or more qualifying children,
  • $40,295 ($45,295 for married filing jointly) if you have two qualifying children,
  • $35,463 ($40,463 for married filing jointly) if you have one qualifying child, or
  • $13,440 ($18,440 for married filing jointly) if you do not have a qualifying child.
The maximum credit you can receive is:
  • $5,657 with three or more qualifying children
  • $5,028 with two qualifying children
  • $3,043 with one qualifying child
  • $457 with no qualifying children
First-time homebuyer credit. The first-time homebuyer credit has been expanded to $8,000 for sales of homes made after December 31, 2008, and before May 1, 2010. The previous requirement that the credit be paid back has been removed. However, if you sell the home within three years (some exceptions apply), the credit must be paid back. Income for qualifying taxpayers is capped at $75,000 for individuals and $150,000 for married couples. The credit is applicable from January 1, 2009, through November 30, 2009.

A reduced credit up to $6,500 is available for homeowners who have lived in their homes at least five consecutive years out of the eight years before buying and moving into a new principal residence. This new credit is for homes purchased after November 6, 2009.

To claim the credit, you must attach to your tax return a copy of Form HUD-1, Settlement Statement, or other settlement statement, showing all parties' names and signatures, property address, sales price and date of purchase.

Making work pay credit. For 2009 and 2010, taxpayers will receive a refundable tax credit of up to $400 for working individuals and up to $800 for married taxpayers filing joint returns. The credit is equal to 6.2% of earned income and will phase out for taxpayers with modified adjusted gross income in excess of $75,000, or $150,000 for married couples filing jointly.

For most taxpayers, the credit will be handled by their employers through automatic withholding reductions, which should put more money into the hands of taxpayers each pay period. The actual amount of the credit will be computed on your 2009 income tax return; self-employed persons or others not subject to withholding can claim the credit at that time. Those who are unemployed do not qualify for the credit.

Other credits, including the energy credit, child tax credit and credit for foreign taxes paid, are available for qualifying taxpayers. Be sure and familiarize yourself with the available credits so you don't miss out.

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