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Credits and Deductions Save You Tax Dollars
by Dianne Molvig
Are you taking advantage of all the tax credits and deductions available to you? Perhaps not, given that tax information gets tougher to wade through every year, says Darrel Shinn, a certified tax professional in Alexandria, Va. "We've had 13 tax law changes since 2001," he says, "and in 2005 alone there were five tax law changes."
No wonder you might miss some credits and deductions you qualify for. We'll look at some of these below, but first a clarification: A tax credit and a tax deduction are not the same.
"A tax credit is almost always better than a tax deduction," explains Cindy Hockenberry, EA, a tax information analyst with the National Association of Tax Professionals, Appleton, Wis. A tax credit reduces your tax liability dollar for dollar, while a tax deduction only reduces the amount you pay taxes on.
For instance, a $100 tax credit entitles you to knock $100 right off your tax bill. With a $100 tax deduction, you subtract $100 from your taxable income. Thus, if you're in the 28% tax bracket, a $100 tax deduction results in $28 in tax savings.
New energy credits
The federal government's Energy Policy Act of 2005 created energy-related tax credits, effective Jan. 1, 2006. That's good news, but ...
"Talk about complicated," Hockenberry says. "They managed to take a relatively simple concept and make it so convoluted that you're just scratching your head."
The tax credits are for:
- Hybrid cars and sports utility vehicles placed in service beginning Jan. 1, 2006
- Central air conditioners and heat pumps
- Furnaces and boilers
- Water heaters
- Metal roofs
- Insulation
- Windows and exterior doors
- Solar energy systems
- Fuel cells
Some of the credits are extremely modest. For instance, you can take only a $200 maximum tax credit for Energy Star-labeled windows. "When you're thinking in terms of spending $10,000 on new windows," Hockenberry points out, "a $200 savings sometimes doesn't even cover the sales tax."
A tax credit is almost always better than a tax deduction.
What's more, a consumer's total credit per tax year for all home energy improvements combined (those listed above but not including solar systems and fuel cells) is capped at $500. Solar panels and solar water heating systems each have a credit for up to 30% of the cost of the system, up to $2,000 for each. For fuel cells, the credit is up to 30% of the cost, up to $500 per 0.5 kilowatt of capacity.
The tax credits on hybrid vehicles range up to $3,400, depending on a vehicle's weight and fuel economy. "But there's a caveat," Hockenberry says, "that once the vehicle manufacturer sells its 60,000th vehicle, the tax credit is reduced, but not until the second quarter after the quarter in which they sold the 60,000th vehicle."
She offers this example: Toyota sold its 60,000th Prius in May 2006. May is in the second quarter of the year. So the first quarter after that quarter is the third quarter, which ended Sept. 30. Anyone buying a Prius after Sept. 30 would get half the original tax credit ($1,575 instead of $3,150). The credit drops further in ensuing quarters.
The above information gives just a taste of what the energy credits are about. Products must meet specified efficiency requirements. To learn more, see:
Commonly overlooked credits and deductions
We asked tax experts to cite key credits and deductions that consumers forget or ignore most often. Here's what our experts had to say.
- Retirement savings credit: This one is at the top of the list for Elizabeth Alexander, a certified public accountant and tax professional in Arlington, Texas. She notes that most people are aware of the deduction they can take for IRA (individual retirement account) contributions. "But what a lot of people don't know," she says, "is that you also can get a credit for putting money into a retirement plan," including IRAs and employer-provided retirement accounts. Adjusted gross income must be less than $25,000 for individuals, $37,000 for head of household, and $50,000 for married couples filing jointly.
The total credit per tax year for home energy improvements combined is capped at $500.
- Higher education credits: The Hope Credit is available for the first two years of postsecondary education. The Lifetime Learning Credit is available every year you, a spouse, or a dependent pays tuition or other qualified expenses. But you can take only one credit in one tax year for the same student. If you're eligible for both, "work it both ways to figure out which is in your favor," Alexander says.
- Charitable contributions: "People know about this tax deduction," Alexander says, "but they don't know how to get the most out of it." The maximum tax deduction you can take for charitable contributions, if you have no receipts, is $500. Many taxpayers simply take the $500 deduction, even if they've given much more to charity.
Say you give a lot of clothes, furniture, and other household items to the Salvation Army. The receipt you get will acknowledge your donations, but show no dollar value. But on the Salvation Army Web site, you'll find a valuation guide for determining the fair market value of donated items. By investing a little time to tally up your donations, you'll create the documentation you need to get the deduction you deserve. Other charities may have similar guides.
- Adoption credit: Adoptive parents may be able to take a credit for qualified expenses of up to $10,630 per qualifying child for 2006. For a special needs child, parents can claim a credit of up to $10,630 regardless of expenses. "The adoption credit has been around for a while," notes Shinn, "but people don't understand which expenses that credit can be used for."
Many people don't know they can get a credit for putting money into a retirement plan--if they're income-eligible.
- Credit for the elderly and disabled: This credit is for low-income people age 65 or older, or if less than age 65, have retired on permanent and total disability. In addition, Shinn advises that low-income elderly homeowners look into state and local credits for their property taxes. While these credits vary by locality, "almost all have some kind of relief," Shinn says.
- Earned income tax credit: Also targeted to low-income taxpayers, "This credit isn't necessarily overlooked," Shinn says, "but it's abused, misunderstood, or miscalculated quite often." A common error is that people taking this credit do not meet the qualifying criteria to be eligible for it. You must file to claim the credit even if you have no tax due.
- Medical and dental deductions: Many taxpayers religiously save every receipt for doctor visits and other health-care expenses, figuring these will be tax-deductible. Disappointment sets in when they discover that, to get a deduction, their medical and dental expenses must total more than 7.5% of their adjusted gross income.
On the other hand, people forget to include some expenses: hearing aids, eyeglasses, contact lenses, crutches, canes, other equipment for disabled individuals, travel to get medical care, uninsured medical and dental expenses, health insurance premiums, and more.
Sometimes you can plan ahead to get the most out of this deduction. For instance, ordinarily Shinn's health expenses wouldn't hit the 7.5% mark. But one year he paid for a hearing aid, his wife's health insurance premiums, regular medical expenses--and then he paid in advance for some dental work. He was able to take a tax deduction. "I wouldn't have been able to qualify," he notes, "if I hadn't done a little planning."
To learn more about all of the above credits and deductions, go to the IRS (Internal Revenue Service) Web site. Enter the appropriate term in the search box. For additional help, see a tax professional.
Published December 4, 2006
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