Step 7: Credits
Tax planning consists of two equally important parts: using deductions to reduce taxable income, and using credits to reduce tax. Tax credits reduce your tax liability. You can claim tax credits for foreign taxes, childcare expenses, college expenses, and adoption expenses. Additionally, you may be eligible for tax credits based on your age or disability, if you contributed to a retirement savings account, and if you have children living with you.
What's a Tax Credit?
Tax credits are a dollar-for-dollar reduction of your tax liability. Your gross tax liability is the total amount of taxes for which you are responsible before any tax credits are applied. Finding your gross tax liability takes a little bit of hunting. On the 2005 tax forms, your gross tax liability is found on Form 1040 Line 46, on Form 1040A Line 28, and on Form 1040EZ Line 10.Tax credits reduce your gross tax liability dollar-for-dollar, but not below zero. Once your tax liability is zero, any additional tax credits are useless. Most tax credits are "non-refundable," which means the excess tax credits expire and are not refunded to you.
Some tax credits, however, are "refundable," which means the excess tax credits can be refunded to you. Only the Earned Income Tax Credit and the Additional Child Tax Credit are refundable tax credits. Using these two credits, your refund can be larger than your income tax withholding, which means you get more money back from the IRS than you have paid-in.
A few tax credits can be carried over to a different tax year. That means any excess tax credits are not lost, but instead can be carried back to a previous tax year, or carried forward to a later tax year. Only the Foreign Tax Credit and the Adoption Tax Credit allow carryovers.
Your net tax liability is the tax for which you are responsible, after all non-refundable tax credits have been applied. Your net tax liability is found on the line called total tax on your tax form. On the 2005 tax forms, this is found on Form 1040 Line 63, Form 1040A Line 38, and Form 1040EZ Line 10. Your withholding is a prepayment against this tax liability, and any excess withholding is refunded to you as a tax refund.
Tax Credits
