Tax Credit

When it comes to taxes, nobody wants to pay more than they own. Missing out on the tax credits you’re eligible for can lead to a significant loss of money that could have remained in your accounts. Understanding what tax credits and their categories are, how they work, and how they differ from tax deductions will allow you to ensure that you’re covering your fair share without overpaying.

What Is a Tax Credit?

A tax credit is a dollar-for-dollar reduction in the amount of taxes you owe. The purpose of this benefit lies in incentivizing desirable behavior that boosts the economy, encourages environmentally-friendly purchases, like buying electric cars or installing solar panels, or supports families that have decided to adopt a child. In turn, federal and state governments grant tax credits and reduce the amount of your income tax.

When reading about tax credits, you’ll likely stumble upon terms like tax deduction. Although often confused, the terms are not interchangeable. How do tax credits differ from tax deductions? Tax credits directly reduce the amount of tax you own, while tax deductions reduce the amount of your income subject to taxes. Simply put, a tax credit reduces the actual tax dollars due, while tax deductions reduce your taxable income.

How Do They Work?

To better understand tax credits, let’s look at how they work. Here’s the underlying principle: if you owe $1,000 in taxes and have a $1,000 tax credit, the tax liability, that is, the amount you’re required to pay, is $0.

For example, after calculating your annual taxes, you’ve determined that you owe $18,000. At the same time, you are eligible for a $1,000 child tax credit. It means that instead of owning $18,000, your annual taxes have shrunk to $17,000.

Types of Tax Credits

Tax credits exist in three categories: nonrefundable, refundable, and partially refundable.

1. Nonrefundable

This benefit is deducted from your tax liability and can reduce your income taxes to zero. Any other amount below zero — a potential refund — will not be returned to the individual. For example, if you owe $300 and have a $400 nonrefundable tax credit, your tax liability is reduced to zero ($400-$300=$100), but you don’t get a $100 refund.

Nonrefundable credits include Child and Dependent Care, Child Tax, mortgage interest, Retirement Savings Contributions, adoption, Lifetime Learning, residential energy, work opportunities, and other dependents credit.

2. Refundable

Refundable tax credits can reduce your income taxes below zero, resulting in a tax refund from the government. So, after your tax payable is reduced to zero, you can claim a $100 refundable tax credit from the previous example.

Refundable credits include Earned Income Tax Credit (EITC) and Premium Tax Credit.

3. Partially refundable

Qualifying for a partially refundable credit means an individual can receive only a certain percent of the credit as a tax refund, even if their tax liability is zero. For instance, the American Opportunity Tax Credit, tailor-made for educational expenses, is partially refundable. If the credit reduces your income taxes to zero, you can get a refund of up to 40% of the remaining credit.

Partially refundable credits include American Opportunity Tax Credit and Child Tax Credit.

Tax credits may be among the most satisfying aspects of your taxes. At the end of the day, nobody wants to pay more taxes than their fair share, and tax credits will allow you to save a substantial sum of money.