Individuals who are eligible for federal income tax credits can significantly lower their tax obligations. It’s important to differentiate between tax credits and tax deductions. A credit usually provides greater tax savings than a deduction, because a credit reduces your tax bill dollar for dollar. A deduction reduces only the amount of income that’s subject to tax.
Here are five major credits for you to consider on the 2020 tax return that you must file in 2021.
1. Higher Education Credits
The tax law gives parents a choice between two possible tax credits for higher education expenses:
American Opportunity Tax Credit (AOTC). With the AOTC, the maximum annual credit is $2,500 per student for each of the first four years of study. The AOTC is phased out based on your modified adjusted gross income (MAGI). For 2020, the AOTC is phased out at between $80,000 and $90,000 of MAGI for unmarried individuals (and between $160,000 and $180,000 for married couples filing jointly.)
Lifetime Learning Credit (LLC). Conversely, the LLC features a maximum annual credit of $2,000 per tax return, regardless of the number of students in the family. This credit is also phased out based on MAGI levels even lower than the ranges for the AOTC for 2020. For 2020, the LLC is phased out at between $59,001 and $69,000 of MAGI for unmarried individuals (and between $118,001 and $138,000 for married couples filing jointly). But unlike the AOTC, the LLC isn’t limited to four years of study.
If you’re eligible for a higher education credit, you must choose one; you can’t claim both. The AOTC is generally more favorable than the LLC on 2020 returns, but what’s right for you will depend on your personal situation. Also note that, for 2021, the new Consolidated Appropriations Act makes the income phaseout ranges for the AOTC and the LLC the same.
2. Child Credit
The Tax Cuts and Jobs Act (TCJA) enhanced the child credit for 2018 through 2025. Under the TCJA, this credit was doubled from $1,000 to $2,000, and the thresholds for phasing out the credit were increased significantly. Furthermore, $1,400 of the child credit is currently refundable, up from a maximum of $1,000.
To qualify for this credit, the child must be:
- Under age 17 at the end of the applicable tax year,
- Your own child, a stepchild or a qualified foster child,
- An individual who didn’t provide more than half of his or her own financial support during the tax year,
- Your tax dependent as defined by prior law,
- A U.S. citizen, a U.S. national or a U.S. resident alien, and
- An individual who lived with you for more than half of the applicable tax year.
In addition, for each qualifying dependent other than a qualifying child (such as a dependent child age 17 or older or a dependent elderly parent), a $500 “family” credit is available.
Important: The child and family credits are subject to an income-based phaseout. But the income ranges are now much higher than before the TCJA.
3. Dependent Care Credit
Separate from the child credit, you can claim a credit for the cost of caring for under-age-13 children and other qualifying dependents (such as an elderly relative who needs nursing care) while you (and your spouse, if you’re married) work. The dependent care credit is 20% for taxpayers with an adjusted gross income (AGI) above $43,000.
The credit is available for the first $3,000 of qualified expenses for one child or $6,000 for two or more children. Thus, you may claim a credit of $600 for the cost of caring for one child or $1,200 for two or more children. But qualified expenses can’t exceed your earned income (if you’re single) or the earned income of the lower-earning spouse.
You may claim the credit for expenses paid to numerous types of providers, including:
- Day care centers,
- Nursing care centers, and
- Certain in-home or outside caregivers.
In addition, the cost of summer day camp — but not overnight camp — qualifies.
4. Adoption Credit
The tax law provides a nonrefundable credit for qualified adoption expenses. For 2020, the maximum credit is $14,300 of the qualified expenses incurred to adopt an eligible child. An “eligible child” is defined as someone who’s under age 18 or physically or mentally incapable of caring for himself or herself.
The credit covers reasonable and legal costs directly related to the adoption, including:
- Adoption agency fees,
- Court costs,
- Attorneys’ fees,
- Travel costs, including meals and lodging, and
- Extra expenses needed to adopt a foreign child.
The adoption credit is subject to an income-based phaseout.
5. Retirement Saver’s Credit
The retirement saver’s credit encourages some taxpayers to set aside money for the future. This nonrefundable credit applies to the first $2,000 voluntarily contributed to a qualified plan, such as a 401(k), a traditional IRA or a Roth IRA.
The credit may equal 10%, 20% or 50% of the qualified contribution, depending on the saver’s AGI. The income levels aren’t very high, and they’re adjusted annually for inflation. For example, an unmarried taxpayer can’t claim a credit if he or she has an AGI of more than $32,500 in 2020 ($65,000 for married couples filing jointly and $48,750 for head of household).
If you qualify, the maximum credit is $1,000 (50% of $2,000). Other special rules may apply. For instance, a taxpayer who was under age 18 last year or is a full-time student can’t claim the credit.
Ready, Set, File
This list isn’t all inclusive. If you want more information about tax credits and other tax breaks available for the 2020 tax year, contact your tax professional.