Tax credits are types of tax benefits that lower your tax bill and, sometimes, increase your tax refund. Taxpayers can claim several different types of tax credits. Each tax credit has its own set of qualifications, and the amount you can receive depends on factors like income and the number of dependents you have.
What is a tax credit?
A tax credit is an amount of money that a taxpayer can subtract directly from their tax bill.
Tax credits differ in value according to their nature; some are granted to particular locations, classifications, or industries.
Quick Definition - A tax credit is a dollar-for-dollar reduction of the income tax you owe.
Giving people tax credits for certain expenses encourages them to spend money on those expenses.
There are three types of tax credits - nonrefundable, refundable, and partially refundable.
1. Nonrefundable Tax Credits
With a nonrefundable tax credit, the amount deducted from the tax liability is deducted directly from the tax liability until it equals zero.
If the taxpayer owes more tax than the amount of the tax credit, the taxpayer does not get a refund, thus the name "nonrefundable." The remaining portion of a nonrefundable tax credit is lost.
Tax credits that are not refundable are valid in the year of filing, expire after the return is filed, and cannot be carried forward into future years.
Nonrefundable credits cannot be used to increase your tax refund or to create a tax refund you wouldn't have had anyway. In other words, you cannot save more than you owe in taxes.
2. Refundable Tax Credits
Refundable tax credits provide the greatest benefit because they are paid in full. An individual is therefore entitled to the entire credit amount, regardless of income or tax liability.
When the taxpayer's tax liability is reduced to $0 or less by the refundable tax credit, a refund is due.
Therefore, your refundable tax credits are treated as tax payments that you have made during the tax year.
Your tax return will list all of your refundable tax credits in the section in which you report your tax payments.
3. Partially Refundable Tax Credits
A partially refundable tax credit provides a portion or percentage of the credit as a tax payment.
A portion of the credit is generally reported as a refundable credit, while the remaining portion is reported as nonrefundable.
How does a tax credit work?
Taking a tax credit results in a dollar-for-dollar reduction of the income tax you owe.
Take the example of owing $5,000 in federal income taxes and claiming a $1,000 tax credit. Your tax bill will be reduced by the amount of the credit, dollar for dollar. So now, instead of having a tax liability of $5,000, you owe $1,000.
$5,000 (tax bill) – $1,000 (tax credit) = $4,000 (remaining balance)
How is a tax credit different from a tax deduction?
In general, tax credits save you more in taxes than deductions. Unlike deductions, credits directly reduce your tax liability, whereas deductions only reduce the amount of your income that is subject to tax.
So, to put it simply - deductions reduce taxable income, whereas tax credits reduce the actual amount of tax due.
The purpose of tax deductions is to reduce your overall taxable income. Come tax time, you pay your tax bill based on your taxable income. Tax credits can reduce your tax bill after it has already been calculated, so after already claiming tax deductions.
Therefore, tax credits are more advantageous than tax deductions because they actually reduce the tax due, not just taxable income. Deductions still reduce a taxpayer's tax liability, but only within their marginal tax rate.
Common Tax Credits
A wide variety of tax credits are offered to taxpayers of all types. Here are a few of the most common and most popular tax credits in the United States.
|2021 Expanded Child Tax Credit||Up to $3,600 per child under age 6, and up to $3,000 per child age 6-17|
|Child Tax Credit||Up to $2,000 per child|
|Credit for other dependents||$500 per dependent|
|American Opportunity Tax Credit||Up to $2,500 per year for four years|
|Lifetime Learning Credit||Up to $2,000 for unlimited years|
|Child and Dependent Care Credit||Up to $8,000 per child or $16,000 for two or more dependents|
|The Retirement Contribution Savings Credit||50%, 20%, or 10% of your contribution|
|Earned Income Tax Credit (EITC/EIC)||Up to $6,660|
How do I claim a tax credit?
Tax credits and deductions can change the amount of tax you owe so you pay less. The best way to take advantage of the best tax credits for you, and thus give you the best chance to pay less tax, 0 tax, or even receive a tax refund, is to use a professional when filing your taxes.
A professional accountant will be able to analyze your unique situation and advise you on the best tax strategies.
There are quite a few grey areas in the U.S. tax code, especially when it comes to tax credits. Before filing your tax return, seek the advice of an experienced CPA or tax professional if you're unsure about your eligibility or how much you might qualify for.
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