How Do Tax Credits Work? Here’s What To Know for 2023
Tax credits enable taxpayers to lower their tax bills or get larger refunds. It’s important to note, however, that these are different from tax deductions, which reduce taxable income rather than the taxpayer’s tax bill directly.
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“The first thing to remember is that credits work differently than deductions,” said Jay Zigmont, PhD, CFP, founder of Childfree Wealth. “While most people in the U.S. take the standard deduction, which lowers your income, tax credits are credited against the tax you owe directly. Additionally, some tax credits are refundable. Refundable credits can result in money coming back to you by making your tax owed negative — giving you a refund.”
A new GOBankingRates survey found that the tax aspect Americans understand the least is how tax credits work, with 37% of respondents saying so.
“Your tax planner or tax software will run you through a series of questions to see what tax credits you may qualify for,” Zigmont said. “Some are obvious, such as the child tax credit, while others you may not be aware of.”
Let’s take a look at some of the tax credits available.
Child Tax Credit
The Internal Revenue Service (IRS) announced that some tax credits, including the child tax credit (CTC), will return to 2019 levels. If eligible, taxpayers will receive a $2,000 CTC for 2022, down from $3,600 per dependent in 2021.
To be eligible, your dependent must be under 17 and your annual income must be under $200,000, or $400,000 if filing a joint return.
In addition, the IRS says the dependent must have lived with you for more than half the year, be claimed as a dependent on your tax return and be a U.S. citizen, U.S. national or U.S. resident alien.
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Child and Dependent Care Credit
To be eligible for this credit, you must have paid for the care of an individual so you could work or look for work, according to the IRS. In addition, there are special rules that apply to military personnel stationed outside the United States.
“Caring for adults — including your spouse, elderly family members and others — may qualify for a dependent care credit if they are physically or mentally unable to care for themselves,” Zigmont said. He noted, however, to “be careful, as you need to care for them for at least half of the year and there are rules about what qualifies.”
A qualifying person generally is a dependent under the age of 13, a spouse or dependent of any age who is incapable of self-care and who lives with you for more than half of the year.
The total expenses that you may use to calculate the credit may be up to $3,000 for one qualifying individual and up to $6,000 for two or more qualifying individuals. The credit ranges from 20% to 35%, depending on your income.
Earned Income Tax Credit
This tax credit helps low to moderate income Americans; the IRS estimates that four out of five workers claim it. As of December 2022, more than 31 million workers and families received about $64 billion in EITC, with an average amount of EITC received nationwide at about $2,043.
“However, there are still millions of people not taking advantage of this valuable credit,” the IRS noted.
The maximum credit amounts are $560 for taxpayers with no qualifying children, $3,733 for workers with one child and $6,935 for workers with three or more children.
To qualify for this credit, your income must be under $59,187, your investment income must be below $10,300 and you must be a U.S. citizen or a resident alien all year.
Saver’s Credit
The Retirement Savings Contributions Credit — aka the Saver’s Credit — is available to taxpayers who made contributions to IRAs or employer-sponsored retirement plans.
The credit is available to those with adjusted gross incomes (AGIs) of up to $73,000 for married filing jointly, $54,750 for heads of household and $36,500 for others.
The maximum contribution amount that may qualify for the credit is $2,000 ($4,000 if married filing jointly), and the maximum credit is $1,000 ($2,000 if married filing jointly). You can receive a tax credit of 10%, 20% or 50% — depending on your AGI.
Adoption Credit
The maximum amount for the adoption credit for 2022 is $14,890 per child. To be eligible, your modified adjusted gross income (MAGI) should be below $223,410.
Also of note: The tax year for which you can claim the credit depends on several factors, including when the expenses were paid, whether it’s a domestic adoption or a foreign adoption and whether the adoption was finalized.
Residential Clean Energy Credit
“If you made energy efficiency improvements to your house, you may qualify for this credit,” Zigmont said. “Be sure to check and see if there is a similar credit at the state level as you may be able to leverage both, and some states have a bigger program than others.”
The residential clean energy credit was set to expire in 2023 but was extended by the passage of the Inflation Reduction Act in August 2022. It represents 30% for all qualifying investments placed in service in 2022.
According to the Congressional Research Service, the credit is 30% off the cost of qualifying electric, water heating or temperature control systems that use solar, wind, geothermal, biomass or fuel cell power.
In addition, some solar roofing tiles and solar roofing shingles also might qualify for the credit.
Foreign Earned Income Exclusion
Zigmont notes that this is not a credit in the same way as the rest of them; it is just meant “to prevent double taxation.”
The foreign earned income exclusion is for American expats working abroad.
As a U.S. citizen or a resident alien expat, you are taxed on your worldwide income.
“However, you may qualify to exclude your foreign earnings from income up to an amount that is adjusted annually for inflation,” the IRS explains.
The 2022 amount is $112,000. One of the criteria to be eligible is that you need to prove you were physically present in a foreign country or countries for 330 full days during any period of 12 consecutive months, including some part of the year at issue, the IRS notes.
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