Tax breaks for the "rich" get a lot of attention, whether they permit major U.S. corporations to pay zero income tax or allow hedge-fund managers to treat earnings as tax-favored capital gains rather than ordinary income. But there are plenty of tax breaks available only for middle- and low-income Americans -- and, in many cases, tapping into them is far easier than the accounting acrobatics the rich must use.
See Tax Breaks for the Middle Class as a slide show.
Breaks for Saving for Retirement
Anyone with earned income (meaning income from work rather than investments) can contribute to a traditional IRA, but not everyone who contributes can claim a tax deduction. That’s a no-no for the rich if they’re enrolled in a retirement plan at work.
Here's how the deduction rules operate for traditional IRAs: First, there's a limit on how much you can contribute each year -- $5,000 ($6,000 if you'll be at least 50 years old by the end of the year) or 100% of your earned income, whichever is less. If you're not enrolled in a 401(k) or some other workplace retirement plan, you can deduct your IRA deposits no matter how high your income. But if you're enrolled in such a plan, the right to the deduction is phased out as 2012 income rises between $58,000 and $68,000 on a single return or between $92,000 and $112,000 if you're married and file jointly with your spouse.
Spouses with little or no earned income can also make an IRA contribution of up to $5,000 ($6,000 if 50 or older) as long as the other spouse has sufficient earned income to cover both contributions. The contribution is tax-deductible as long as income doesn't exceed $173,000 on a joint return. You can take a partial tax deduction if your combined income is between $173,000 and $183,000. The limits only apply if one spouse participates in an employer plan. If neither does, there are no income limits for taking a deduction.
The IRA deduction is an “above the line” adjustment to income, meaning you don’t have to itemize your deductions to claim it. It will reduce your adjusted gross income dollar for dollar, lowering your tax bill. And your lower adjusted gross income (AGI) could make you eligible for other tax breaks, which disappear at higher income levels.
Of course, no one gets to deduct contributions to Roth IRAs. That’s the trade-off for getting tax-free withdrawals in retirement, rather than the taxable cash that comes out of traditional IRAs. (And, by the way, folks with incomes over $125,000 on a single return or $183,000 on a joint return can’t even contribute to a Roth IRA.)
Save and Be Credited
If you are single and have adjusted gross income of $28,750 or less for 2012, or you are married and have AGI of $57,500 or less, you can make out even better on a 2011 IRA or 401(k) contribution through the Saver's Tax Credit.
The credit is a potential bonanza for part-time workers who fall within the income limits. You can claim a tax credit worth 10% to 50% of the amount you put in, up to a maximum credit of $1,000 ($2,000 for joint filers).
The lower your income, the higher the percentage you get back via the credit. Some key exceptions: Taxpayers under age 18, full-time students and those claimed as dependents on their parents' returns are not eligible, regardless of their income.
And here's the beauty of a credit compared with a deduction: While deductions reduce the amount of your income that can be taxed, credits reduce the amount of tax you owe -- dollar for dollar.
Get Paid (More) for Working
The government provides an incentive for people to work: the Earned Income Tax Credit. For 2012, the maximum EITC ranges from $475 to $5,891, depending on your income and how many children you have. This program, originally conceived in the 1970s, has been expanded several times, and some states (and even municipalities) have created their own versions.
Part of what makes it popular: When the federal EITC exceeds the amount of taxes owed, it results in a tax refund -- a check back to you. In essence, you’re no longer a taxpayer. But, you have to act to claim the credit by filing -- a step many don’t take.
The income limits on this program are fairly low. If you have(no kids, for example, your earned income and adjusted gross income (AGI) must each be less than $13,890 if you're single and $19,190 if you're married filing jointly. If you have three or more kids and are married, though, your earned income and AGI can be as high as $50,270. The exceptions are considerable -- more complicated than we can list here -- but the IRS has a helpful online calculator to help you determine eligibility.
Your Child, Your Credit
With a new baby also comes a $1,000 child tax credit to lower- and middle-income earners, and this is a gift that keeps on giving every year until your dependent son or daughter turns 17. You get the full $1,000 credit no matter when during the year the child was born (which is why people make gags about speeding deliveries as the New Year approaches).
Unlike a deduction that reduces the amount of income the government gets to tax, a credit reduces your tax bill dollar for dollar. So the $1,000 child credit will reduce your tax bill by $1,000. The credit begins to disappear as income rises above $110,000 on joint returns and above $75,000 on single and head-of-household returns — although there’s no limit to how many kids you may claim on a return, as long as they qualify. And for some lower-income taxpayers, the credit is "refundable," meaning that if it’s worth more than your income tax liability, the IRS will issue you a check for the difference, as with the EITC.
Zero Tax on Capital Gains
Normally, long-term capital gains (and qualified dividends) are taxed at a maximum rate of 15% -- a bargain by historical standards. That's why some people get so exercised about a rule that allows hedge-fund managers to pay tax at the capital-gains rate rather than at rates for ordinary income, which top out at 35%.
But investors in the two lowest income tax brackets will pay no tax at all on their capital gains and dividends. That could be a boon to retirees, who have a higher standard deduction than younger taxpayers and who are not taxed on some or all of their Social Security benefits, and the unemployed, who may have had to tap their investments to make ends meet.
To take advantage of the 0% capital-gains rate for 2012, your taxable income can't exceed $35,350 if you are single; $47,350 if you are a single head of household with dependents; or $70,700 if you are married filing jointly. Note that this is taxable income. That's what's left after you subtract personal exemptions -- worth $3,800 each in 2012 for you, your spouse and your dependents -- and your itemized deductions or standard deduction from your adjusted gross income. This break is scheduled to expire after 2012.
American Opportunity Credit
This tax credit, which has been extended through 2012, is available for up to $2,500 of college tuition and related expenses paid during the year. The full credit is available to individuals whose modified adjusted gross income is $80,000 or less ($160,000 or less for married couples filing a joint return). The credit is phased out for taxpayers with incomes above those levels.
The American Opportunity Credit is juicier than the old Hope Credit -- it has higher income limits and bigger tax breaks, and it covers all four years of college. And if the credit exceeds your tax liability (whether derived from the regular income tax or the alternative minimum tax), it is partially refundable.
Lifetime Learning Credit
If you want to get additional education -- for virtually any reason and at virtually any school -- you can tap the Lifetime Learning Credit. The credit is calculated as 20% of up to $10,000 of qualified expenses, so you can get back $2,000 per year.
The income limits for the Lifetime Learning Credit are $60,000 if single and $120,000 if married, and you can’t claim both this credit and the American Opportunity Credit for the same student in the same year. Also, no double dipping allowed: Expenses paid with funds from other tax-favored tuition programs, such as a Coverdell ESA, don’t count when figuring either credit.
More Education Breaks for Middles
If neither the American Opportunity Credit nor the Lifetime Learning Credit breaks your way, there are still other ways the government offers favorable tax treatment for learning -- and limits the breaks to the middle class and below.
1) Got a student loan around your neck? You can deduct up to $2,500 of interest paid on the loan each year, so long as your modified adjusted gross income (MAGI) is less than $75,000 ($150,000 if filing a joint return). The former student can deduct this even if it's actually Mom and Dad who are paying the bill.
2) Interest on savings bonds is usually subject to federal income tax. However, interest on Series EE and I bonds issued after 1989 can be tax-free when used to pay for qualified education expenses, if you meet certain requirements. This benefit phases out when your 2012 MAGI is between $109,250 and $139,250 for those filing jointly, and between $72,850 and $87,850 for other filing statuses.
3) Don’t forget about the tuition and fees deduction. Deductions don’t have the power of tax credits (such as the American Opportunity and Lifetime Learning credits). But if you can’t make those work for you, you can still reduce your income subject to tax by up to $4,000 for tuition and other qualifying educational expenses you pay during the year, as long as your MAGI doesn’t exceed $160,000 if filing jointly, or $80,000 if filing any other way.