As you know, there are many ways to reduce your taxes. One of the most popular is through the use of tax credits. Tax credits are valuable because they reduce your taxes on a "dollar for dollar" basis. Unlike deductions (which reduce your taxes only on a percentage basis based upon your marginal tax rate), credits reduce your actual tax liability directly. Tax credits also can be used regardless of whether or not you itemize your deductions.

There are a vast number of credits. Many have been around for years, and are quite popular (such as the dependent care credit). Some are new, and provide an exciting way to reduce your tax liability (such as the child tax credit). Others are more obscure to most taxpayers and only apply to special taxpayers in special situations (such as the enhanced oil recovery credit). But you should know that there are a LOT of credits out there that can help you reduce your total taxes.

Many credits are discussed in greater detail here in the Taxes area. You might want to check 'em out. Other credits, since they are not applicable to the general public, have not been discussed. But it is important that you know more about these credits and how they work, which is why this overview of credits is presented for your reading pleasure.

Income tax credits may be broken down into five basic groups:

1. Nonrefundable personal credits
2. Miscellaneous nonrefundable credits
3. Refundable credits
4. The general business credit, and
5. The credit for the prior year minimum tax liability.

The nonrefundable personal credits include the household and dependent care credit (commonly known as the child care credit), the credit for the elderly and disabled, the adoption expenses credit, the HOPE and Lifetime Learning education credits, and the home mortgage interest credit. As their names suggest, these credits are for personal expenses and are applied to reduce your regular tax liability (but not below zero). They may not be refunded if they exceed this limitation. If there is an excess credit, only the adoption expenses credit and home mortgage interest credit may be carried forward to another tax year.

The nonrefundable personal credits, as with the other credits discussed below, may be applied only to the excess of the regular income tax liability over the tentative minimum tax liability. The purpose of this limitation is to disallow any credit that could be applied against any tentative minimum tax liability. Obviously, if you are liable for the alternative minimum tax (AMT), you will be unable to use any tax credits against it. This rule will not apply for taxable years beginning in 1998, but may certainly apply in the future. So if any of these credits apply to you, you must really understand the AMT rules in order to determine if these credits will reduce your regular tax liability.

The miscellaneous nonrefundable credits include the foreign tax credit, the non-conventional source fuels credit, the qualified electric vehicle credit, and the Puerto Rico economic activity credit. Although none of these credits are refundable, any unused foreign tax credit may be carried back as much as two years and forward as far as five years.

The refundable credits include: the credit for taxes withheld on wages and other amounts, the earned income credit and the child tax credit, which are designed to aid low-income taxpayers; the credit for tax withheld on payments to nonresidents and foreign corporations; and the gasoline and special fuels credit. Each of these credits may be refunded to you if the amount of the credit exceeds your tax liability for the year in question. Thus, it is not necessary to provide for a carryover of any of these taxes, since the excess may be received in the form of a tax refund.

The general business credit encompasses a number of credits designed to encourage certain business activities. These credits are the investment tax credit, which consists of the rehabilitation credit, the energy credit, and the reforestation credit, the work opportunity credit, the alcohol fuels credit, the research credit, the low-income housing credit, the enhanced oil recovery credit, the disabled access credit, the renewable electricity production credit, the empowerment zone employment credit, the Indian employment credit, the employer Social Security credit, the orphan drug credit, the trans-Alaska pipeline liability fund credit, the community development credit, and the welfare-to-work credit.

The prior year minimum tax credit is designed to reimburse taxpayers for AMT paid in earlier years as a result of certain "deferral" items. Deferral items are preference items, such as accelerated depreciation, which do not result in a permanent reduction in regular tax liability. The credit is available to individuals, corporations, trusts and estates. As with any AMT item, the rules for calculating and applying it are complex.

As you can see, there are a number of credits that may be used to reduce your income tax liability. This is only a summary of the available credits. You'll find a discussion on many of these credits here in the Taxes FAQ area. But if there is a credit noted above that you believe may apply to you, and on which you need a bit more information, you can always post your question in the Tax Strategies message board. I'll be glad to provide you with an overview of any specific credit that you might have an interest in.

Want to learn more about taxes and investing? The Motley Fool Investment Tax Guide is now available through FoolMart. There is still time available to do that tax planning (and tax saving) before the end of the year. Click here to read more about this Investment Tax Guide.

- 02/26/99

Reprinted by permission. Disclaimer
© Copyright 1999, The Motley Fool.
All rights reserved.