What Are Tax Credits and How Do They Work?

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With tax season just around the corner, many people are looking for ways to reduce what they owe or increase their refund. Two basic ways to do that are through tax deductions and tax credits. While the two terms are sometimes used interchangeably, they refer to two different things.

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As explained by Investopedia, tax deductions reduce your taxable income whereas tax credits reduce the amount of taxes owed. If you have specific questions about which tax credits (or deductions) you qualify for it is best to speak with a tax professional.

Many people are eligible for one or more tax credits. They are generally considered more advantageous than deductions because they can significantly reduce the amount of money you owe. Read on to find out more about tax credits and how they work. 

What Are Tax Credits?

Tax credits reduce your overall taxes, which means that you may owe less or receive a larger refund. 

Governments use tax credits to help offset expenses for taxpayers or as incentives for certain behaviors, like using an electric vehicle. Tax credits are generally viewed as more favorable than tax deductions because they are a dollar-for-dollar reduction.

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What Are Common Tax Credits?

There are several kinds of tax credits offered by the federal government. The Internal Revenue Service (IRS) provides detailed information about the tax credits that it offers individuals. 

Common federal tax credits include:

  • Child tax credit
  • Child and dependent care credit
  • Earned income tax credit
  • Adoption credit
  • Residential energy credit
  • Electric vehicle credit
  • Premium tax credit

States also offer credits to taxpayers. California, for example, offers credits for renters, child care and college students. 

How Do Tax Credits Impact My Taxes? 

Turbotax notes that tax credits are a “dollar-for-dollar reduction of your income.” To claim a tax credit, you must first determine your eligibility. If you believe that you qualify for a tax credit, you can claim it on your tax return. The IRS offers an Interactive Tax Assistant for some credits to determine whether you qualify. 

Tax credits will reduce the overall taxes that you owe. It is important to pay attention to the specific eligibility requirements of each credit. Your income may alter whether you qualify for the credit or may reduce the amount of the credit that you can receive (partial credit).  

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Why Tax Credits Matter

Tax credits are one of the most useful tools available to reduce the amount of taxes you owe. In some instances, they may even result in a refund despite you not owing any taxes. A firm understanding of available state and federal credits can help ensure that you are only paying what you owe or receiving the largest possible tax refund. 

Before you file your taxes this year be sure to review all of the possible credits and deductions that you may be eligible to receive. You could save big just by taking a credit you already qualified for. 

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