What is a Tax Credit?

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Definition:

A tax credit reduces how much you owe in taxes — As compared to a tax deduction (which reduces your taxable income), a tax credit is an amount subtracted from the total taxes you owe.

🤔 Understanding tax credits

Tax credits reduce the amount of money you owe in personal income taxes. Instead of reducing the amount of income that is taxable (that's what tax deductions do), a tax credit can be subtracted dollar-for-dollar after all of the deductions are finished. By subtracting from the taxes owed, your tax burden may be reduced or eliminated. Some tax credits are refundable, while others are nonrefundable. A nonrefundable credit may reduce your taxes to zero but if the credit is more than what you owe, you won’t get any money back. A refundable tax credit, on the other hand, may result in you getting money back from the government.

Example

A common income tax credit for families is the child tax credit, which allows parents or guardians to subtract $2,000 for each qualifying child on their 2020 income tax return. Up to $1,400 of that tax credit can be refunded, even if the parent or guardian owes no taxes. The same is true for the 2021 tax year.

Takeaway

A tax credit is like a gift card...

If you’re buying new hiking boots, a gift card may reduce their total cost. You just have to pay the difference, if any remains. Likewise, a tax credit can reduce how much you owe in taxes, or even eliminate your tax bill entirely.

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How do tax credits work?

Tax credits reduce the amount of taxes you must pay. When you file income taxes, the amount of taxes you owe to the government is based on the amount and type of income you earned during the year.

Typically, you start by reporting all of your income (your gross income), and then subtracting allowable expenses to calculate your adjusted gross income (AGI). Once you find your AGI, you can then subtract any tax deductions for which you qualify. For many, this is the standard deduction amount.

Now you can calculate the total taxes you might owe, based on which tax brackets your income falls into and the corresponding tax rates. Remember, the U.S. has a progressive tax system, so your taxable income may fall into multiple brackets.

After you arrive at a tax amount, you can determine which tax credits you qualify for, if any. If you qualify for tax credits, you can subtract them from the bill as an instant and direct reduction.

As an example, let’s say you owe $500 in income taxes, but you qualify for a $200 tax credit. You would subtract the $200 and owe just $300 in taxes instead of the original $500.

But what if your tax bill is only $150 yet you still qualify for a $200 tax credit? The results of that scenario depend on what type of tax credit you’re claiming.

What are the types of tax credits?

Tax credits are generally refundable or nonrefundable, though some can be partially refundable.

  • Refundable: A refundable tax credit is one that generates a tax refund for you when it is higher than the amount of tax you owed. If your income tax liability for the year is $200 and you qualify for a refundable tax credit of $300, you could receive an income tax refund of $100.
  • Nonrefundable: This type of tax credit will reduce your taxes to zero but will not create a negative balance that triggers a refund. So, if your taxes are $200 and you receive a nonrefundable tax credit of $300, then your tax liability is simply reduced to zero.
  • Partially Refundable: A few tax credits can generate refunds that are only part of the total. The American Opportunity credit is a good example. This is an educational credit that reduces your taxes, but if it creates a refund, then you can only receive 40% of what’s left of the credit, up to a maximum of $1,000.

What is the difference between a tax deduction and a tax credit?

Tax credits and tax deductions affect your income taxes in two distinct yet important ways. Essentially, tax credits directly reduce the amount of taxes you owe, and tax deductions reduce the amount of income you are taxed on.

Tax deductions reduce your taxable income (the amount that you pay taxes on after you have applied eligible deductions) and can affect which tax bracket you’re in — In other words, it can cause the percentage of overall taxes you pay to change. Tax credits, on the other hand, specifically reduce your tax bill dollar-for-dollar regardless of which tax bracket you’re in.

To look at a simplified example: Let’s say you earned $1,000. If your tax bracket is 30%, your tax bill is $300 without any deductions or credits.

A $200 tax deduction means only $800 of your income is taxable. Assuming you’re still within the 30% bracket, your tax bill is now $240.

A $200 tax credit, however, is subtracted from the original $300 tax bill. Thus, you’d owe just $100.

What are some common tax credits?

The biggest tax credits are generally focused on helping low-to-moderate-income families. They are typically designed for people who work for their income, have families, and work to improve themselves through education and saving. Some examples are:

Earned Income Tax Credit: This tax credit is meant to provide assistance to low- and moderate-income workers who are either employed or running their own small business. This is a refundable credit that can generate an income tax return even if you are not required to file.

The Earned Income Tax Credit (EITC) is most beneficial for families with children, but it is also useful for single or married filing jointly without children if their income is quite low ($15,820/$21,710 for 2020 and $15,980/21,920 for 2021). The EITC is based on a sliding scale and has maximum credit limits. In 2020, for instance, a family filing jointly can receive up to $6,660 if they have three or more qualifying children and their adjusted gross income is less than $56,844. In 2021 this family can receive up to $6,728 if their adjusted gross income is less than $57,414.

Educational Credits: Two tax credits serve to stimulate higher education for qualifying individuals. If you, your spouse, or one of your dependents is enrolled in a qualifying higher educational institution, you may qualify for the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit (LLC).

The AOTC provides up to $2,500 for each eligible student for four years. This credit is designed to offset the costs of higher education and is 40% refundable. This tax credit is available to single taxpayers with an adjusted gross income of up to $90,000 and married filing jointly with an AGI of up to $180,000.

The LLC allows you to be reimbursed for up to $2,000 per tax return (nonrefundable) if your adjusted gross income is under $69,000 ($138,000 married filing jointly in 2020), and you meet the other requirements. This credit does not limit the number of years it can be used, and it applies to job skills improvement as well as college or other higher education.

Child and Dependent Credits: There are several dependent-related tax credits, with the most common being the Child Tax Credit. This credit is provided for families with qualifying children under the age of 17. Generally, a minimum of 50% of the cost of support for the child must be paid for by the taxpayer claiming the credit, and no one else (including the child) claims them on a different tax return. Similar tax credits are available to help supplement the cost of child or dependent care and the costs associated with adoption.

Savers Tax Credit: This tax credit rewards you for putting money into a retirement account. If you contribute to an Individual Retirement Account (IRA), Achieving a Better Life Experience (ABLE) account, or another eligible employer-sponsored retirement plan, then you can claim a percentage of your contribution as a tax credit up to $2,000 ($4,000 if married filing jointly). Lower-income earners are allowed to receive 50% of their contributions as a credit, and the credit is phased out above incomes of $32,5000/$65,000 in 2020 and above incomes of $33,000/$66,000 in 2021.

Residential Energy Tax Credit: This credit varies from one year to the next, but generally, homeowners can receive nonrefundable credits to offset investments made to improve the energy efficiency of their home. If you installed a solar water heater in 2019, for instance, you could qualify for a tax credit of up to 30% of the cost. This reduces to 26% and 22% in later years.

What tax credits do I qualify for?

Since each tax situation is unique to the individual filing, we cannot tell you exactly which credits you specifically qualify for. We can, however, explain the criteria for the most common ones.

Generally, both the qualifications and the amount you can qualify for depend upon your adjusted gross income and the year you are filing for.

  • Children/Adoption: If you have one or more children living with you, or that you provide more than 50% of the total support for annually, you likely qualify for the child tax credit. For the 2020 and 2021 tax year, this is $2,000 per child. Similarly, there is an adoption tax credit to help offset expenses associated with adopting a child. In 2020, that was a nonrefundable credit of up to $14,380 per child and up to $14,440 per child in 2021.
  • Childcare/Dependent Care: When you pay for child care, elderly care, or care for disabled dependents so that you can work or look for work, you may be eligible for the childcare and dependent care tax credit. This tax credit can be up to $3,000 per qualifying dependent with a maximum of $6,000.
  • Earned Income: This tax credit is available on a sliding scale basis and is available for low-to-moderate-income earning individuals or couples. If you earn your income from working or running a small business instead of through investment or other passive income, you may qualify for this refundable credit. This credit is the most beneficial to families with qualifying children, but it can be helpful to low income individuals as well.
  • Education: Educational tax credits can be partially refundable and are designed to cover higher education expenses. If you, your spouse, or a dependent is in college, you may qualify for the AOTC for four years, and if you pay for job-related education expenses, you may qualify for the LLC each tax year that it is applicable for you.
  • Green Energy: If you work to make energy-efficient improvements to your home, you may qualify for energy tax credits. Some of the more common home improvements that might qualify for the energy tax credit include adding solar or wind power and installing energy-efficient doors or windows.

Most do-it-yourself tax filing systems help walk you through each of the tax credits for which you might qualify. When in doubt, or if it just seems too confusing or overwhelming, consult with a professional tax advisor for the best results.

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