A tax credit reduces the dollar-for-dollar amount of income tax that a taxpayer owes to federal and individual state governments. Tax credits may be granted to encourage and reward specific types of behavior that governments consider beneficial to the economy or environment.
The value of a tax credit depends on the nature of the credit. For example, tax credits are available to those who install solar panels at their home, those who adopt, and those who send their child or dependent to day care.
A tax credit differs from a tax deduction, and is more favourable because it reduces the tax amount due, not just the amount of taxable income.
What Types of Credits Are There?
Tax credits can be divided into three categories, including:
Refundable tax credits
Refundable tax credits are the most beneficial because the taxpayer is entitled to the entire value of the credit, meaning it can entirely reduce their tax liability, and they can pocket some extra money.
For example, if you owe the government a $2,000 tax payment for the year, but you’re eligible for a $2,500 refundable tax credit, your tax liability will be eliminated and you’ll receive a $500 refund.
One of the most commonly claimed refundable credits is the Earned Income Tax Credit (EITC). It is available to low- to moderate-income taxpayers who meet specific income and family criteria. The Premium Tax Credit and the Fuel Tax Credit are also refundable.
Nonrefundable Tax Credits
Nonrefundable tax credits are directly deducted from an individual’s tax liability. Any tax credit amount greater than the tax owed is not paid out as a refund.
For example, if you owe the government a $2,000 tax payment for the year but are eligible for a $2,500 refundable tax credit, your tax liability will be eliminated. However, you won’t receive the unused $500 as a refund.
One of the most commonly claimed nonrefundable tax credits is the Child and Dependent Care Credit. It helps individuals and couples who are working or seeking work reduce the costs of care for children under 13. The Lifetime Learning Credit and the Adoption Credit are also nonrefundable tax credits.
Partially refundable tax credits
Some tax credits are only partially refundable. For example, if your credits reduce your tax liability to $0 but you haven’t used the entire $2,500 credit, you’ll receive either $1,000 or 40% of the remaining credit (whichever is less) as a refund.
One of the most commonly claimed partially refundable credits is the American Opportunity Tax Credit (AOTC). It helps eligible students pay for qualified education expenses for the first four years of college. The Child Tax Credit is also partially refundable.
Tax Credits vs Tax Deductions
Tax credits and tax deductions both help to reduce the amount of money an individual owes to the government in a single year. However, they differ in how they do so, as tax deductions aim to reduce taxable income before it is taxed.
For example, the monthly contributions that you make to a 401(k) or a Health Savings Account (HSA) reduce your taxable income by the total amount contributed that year.
You can choose to take the automatic standard deduction offered to everyone, or you can itemize your own deductions. If choosing the latter, you’ll have to provide documentation for the deductions you itemize.