What Is a Tax Credit?
A tax credit reduces the amount of income tax you owe the government by a specified amount. Unlike a tax deduction, which decreases the amount of your income that is taxed, a tax credit reduces your final tax bill. Some tax credits can also be used to increase your tax refund beyond the amounts withheld or overpaid.
How Do Tax Credits Work?
Tax credits are a dollar-for-dollar reduction of your liability for the tax year. For example, suppose you had $60,000 in adjusted gross income in 2022 and were eligible to claim a $500 tax credit. If you are married filing jointly, the federal income tax due on $60,000 in gross income would be $3,681. The $500 tax credit would then reduce the tax liability reported on your tax return to $3,181.
Tax deductions decrease a taxpayer's adjusted gross income, which is the amount subject to the federal income tax. People are usually more familiar with tax deductions because they are generally claimed more often than tax credits. Common tax deductions include the standard deduction, the deduction for donations to nonprofits, and the student loan deduction. The self-employed can often take advantage of additional deductions.
The difference between a tax credit and a tax deduction may seem like a minor distinction, but it can have a significant impact on your federal tax return. To illustrate how a deduction differs from a credit, let's use the facts of the example above and give you a $500 tax deduction instead of a credit. The tax deduction will reduce your 2022 adjusted gross income from $60,000 to $59,500 and result in a $3,621 tax bill, a reduction of $60. Thus, with the same $60,000 in income, a $500 tax credit gives you $500 in tax savings, while a $500 tax deduction gives you $60 in tax savings.
One advantage a tax deduction has over a tax credit is that by reducing your taxable income, the deduction may move you into a lower tax bracket. That generally means you will pay a lower tax rate.
Refundable and Nonrefundable Tax Credits
There are two types of federal tax credits: refundable and nonrefundable. A refundable tax credit is one where the government will pay the taxpayer the total tax credit amount, even if it exceeds the amount of taxes owed. In other words, if a taxpayer can claim a tax credit of $750 but only owes $500 in taxes, the taxpayer can expect a tax refund of $250 since that is the amount of the credit that exceeds the taxpayer's tax liability.
As the name suggests, nonrefundable tax credits can eliminate a taxpayer's liability but not exceed your tax liability. Therefore, you will not receive a tax refund from the government if the credit exceeds the total tax amount owed.
Refundable credits are often used by the federal government to give additional money to certain types of individual tax filers and businesses. For example, the child tax credit (CTC) can provide extra income to working parents with a qualifying child because up to $1,500 of the credit is refundable. Likewise, the credit for increasing research activities offers extra money for businesses as an incentive for keeping research and development activities in the United States.
Types of Tax Credits Available for Individual Taxpayers
There are several different federal tax credits available to individual taxpayers who qualify based on the taxable income reported on their federal income tax returns. Certain credits and deductions may only be available to low-income or moderate-income taxpayers. Eligibility for credits may depend on your tax filing status, income, and other factors. Some of the most common tax credits for individuals include:
- Child tax credit (CTC)
- Earned Income Tax Credit (EITC)
- Child and dependent care credit
- Saver's credit for contributions to individual retirement accounts (IRAs) or employer-sponsored retirement plans
- Residential energy efficient property credit
- American opportunity tax credit
- Lifetime learning credit
The Inflation Reduction Act of 2022 added or changed tax credits for energy-efficient upgrades to your home, like adding solar panels.
Determining Your Eligibility
The rules for determining who is eligible for various tax credits can complicate tax preparation, and the IRS may subject you to penalties if you claim a credit for which you are not eligible. Fortunately, most tax software, such as TurboTax, does a good job of asking questions to determine whether you are eligible. Tax professionals and tax attorneys can also be helpful in assessing your eligibility.
State Tax Credits
Many states offer their own tax credits that can be claimed along with any federal credits to which you are entitled. For example, many states offer their own version of the child tax credit that is often based on the taxpayer's eligibility for the federal CTC.
Additional Questions? A Tax Lawyer Can Help
Tax laws can be complicated, especially when you are unsure whether you qualify for tax credits and deductions. If you have questions about your eligibility for a tax credit, it may help to consult with a local tax attorney.
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