What Is a Tax Credit?

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Tax credits can literally put thousands of dollars back in your pocket–and are more powerful than regular tax deductions. In fact, Americans leave billions of dollars on the table each year by not claiming the right tax credits and deductions, according to CNN. But what exactly is a tax credit, and how do they work? We’ll break it all down, plus show you a few common credits you might be eligible for this year. 

See Also: Owe Money to the IRS? Most People Don’t Realize You Can Do This

What Is a Tax Credit?

Dollar-for-dollar, a tax credit reduces the amount of taxes you owe, such as if you have to pay capital gains taxes or income taxes. These credits can vary by tax year, depending on what you may qualify for. For example, if you are eligible for a $300 tax credit, your tax is reduced by that amount, leading to an exact savings of $300. If you’re owed an income tax refund, a refundable tax credit could increase it for that year.

Tax credits are different from tax deductions. Tax deductions reduce your taxable income, which in turn lowers the amount of income subject to taxation. For example, if you earn $60,000 and claim a $4,000 deduction, your taxable income becomes $56,000. But this doesn’t save you $4,000, but saves you from being taxed on $4,000 in income, so the savings is much less than a tax credit. Common deductions are mortgage interest, medical expenses and charitable contributions.

How Do Tax Credits Work?

Tax credits reduce your overall tax bill–and in some cases–refund the difference of what you owe and the size of the credit. This is a dollar-for-dollar reduction in your taxes, whereas a tax deduction only lowers you taxable income.

Tax credits are more valuable than deductions in most cases, but are usually offered to those with low-to-moderate incomes. Tax credits also encourage spending on things like education, investing, and raising children or taking care of dependents. 

Common Types of Tax Credits

Federal tax credits can help reduce low-to-moderate-income taxpayers’ taxes and potentially maximize their income tax refund. Here are five of the most common tax credits you can take advantage of if you qualify.

1. Earned Income Tax Credit. EITC was established in 1975 and is designed to incentivize taxpayers to work and alleviate their Social Security tax burden. The amount of EITC varies based on a taxpayer’s adjusted gross income, earned income, investment income, filing status and number of qualifying dependent children. This is a refundable tax credit, meaning if it exceeds the amount of tax owed, a taxpayer may receive the excess amount as a refund.

2. Child Tax Credit (CTC). This tax credit is for the parents or guardians of dependent children age 17 or younger. You can claim a tax credit of up to $2,000 for each qualifying child dependent, with up to $1,400 of the credit being refundable. This means if you have four qualifying children, you can get up to $8,000 in credits for the year. Qualifying for this requires being under a certain income threshold determined by your filing status.

3. Child and Dependent Care Credit. This tax credit is available to taxpayers with dependent children and helps reduce childcare costs, such as daycare and babysitting. It covers the costs of caring for dependent children under age 13 so parents can work or look for employment. This credit is also available to taxpayers caring for a dependent of any age, including a spouse who is physically or mentally incapable of caring for themselves. 

Qualifying filing status for child and dependent care credit includes:

• Single
• Married filing jointly
• Head of household
• Qualifying widow or widower with a qualifying child

4. American Opportunity Tax Credit. Initially named the Hope Credit and renamed in 2009, this credit benefits students pursuing higher education and can be worth up to $2,500 per eligible student for the first four years of post-secondary education. AOTC covers tuition, fees and course materials. Students must be enrolled at least part-time for at least one academic school period.

5. Lifetime Learning Credit. This educational expenses credit provides up to $2,000 per income tax return for qualified tuition, fees and related expenses. Unlike AOTC, there’s no limit on the number of years taxpayers can claim this credit. Taxpayers are not required to pursue a degree for eligibility, but the credit is phased out as income surpasses the maximum allowed threshold based on filing status.

6. Savers Tax Credit. Formerly the Retirement Savings Contributions Credit, this credit allows taxpayers to make retirement plan contributions. Qualified investment retirement accounts include 401(k)s and certain retirement plans. The lower a taxpayer’s income, the higher the credit. Single filers are eligible for up to $1,000, while joint filers can get up to $2,000.

7. Premium Tax Credit. The Premium Tax Credit offers a credit to help pay for excess premium costs of health insurance purchased through the healthcare marketplace. This credit is designed for low- and moderate-income families earning up to 400% of the federal poverty line and is available only to those enrolled in a marketplace health insurance plan. This tax credit uses an industry benchmark price for a healthcare plan, and offers a credit for the amount paid over that benchmark for the year.

While these seven are the most common, there are many others offered by the IRS, such as the adoption credit, residential energy credit, and electric vehicle credit. Certain states also offer tax credits to offset state taxes. 

Refundable vs. Nonrefundable Tax Credits

Some tax credits are refundable, but others are not. Here’s how they compare:

Refundable tax credits. A refundable tax credit will increase your tax refund, regardless of whether or not you owe income taxes on your return. This means if you’re already getting a refund, a refundable credit will add to your overall refund amount. Some tax credits are only partially refundable, though, so you’ll need to calculate how much you can claim for each refundable credit you qualify for.

Nonrefundable tax credits. Many tax credits are not refundable, meaning if you’re already getting a refund, they will not increase that refund. Nonrefundable tax credits are ideal for lowering the taxes you owe, but can only lower your income taxes down to $0, and will not result in a refund. 

How Tax Credits Can Affect Taxes

Tax credits can reduce or, in some cases, eliminate tax liabilities. For example, if an individual taxpayer owes $2,500 in taxes but qualifies for a $1,500 tax credit, their tax bill is reduced to $1,000. Some tax credits are refundable, allowing taxpayers to receive a refund if the tax credit exceeds their tax liability. 

How to Claim Tax Credits

To claim a tax credit, you first need to research if you meet all the qualifications. There may be relationship requirements, income maximums, and other prerequisites you must meet to claim a credit. 

You’ll want to fill out the proper form (or use tax software) to calculate how much of the credit you can claim. Each tax credit typically comes with its own IRS form and instructions for how to claim the credit. These forms must be completely filled out and attached to your tax return when filing your taxes.

Finally, it’s usually a good idea to use tax software that can guide you through each credit to verify if you qualify, and how much you can claim. Or you can choose to work with a licensed tax professional to ensure you’re getting the largest refund possible on your tax return.

How to Maximize Your Tax Credits

To get the most out of your tax credits, it’s a good idea to meet with a tax professional that can help with tax planning to ensure you qualify for the credit completely. For some credits, you’ll need to ensure you meet all qualifications before the year ends, so meeting with a tax pro before end-of-year can be a good idea. 

It’s also a good idea to read through the criteria for common tax credits to see what you might qualify for. Some credits (like the Energy-Efficient Home Improvement Tax Credit) are lesser-known but can provide thousands in reduced taxes. 

Final Take

Tax credits are powerful tools for taxpayers to reduce tax liabilities and retain more of their income. These credits can make pursuing higher education, taking care of children and investing in retirement more financially possible. By understanding tax credits and how they work, you can maximize your tax savings and reach your financial goals.

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