Tax Credit

Loading the player...

What is a 'Tax Credit'

A tax credit is an amount of money a taxpayer is able to subtract from taxes owed to the government. The value of a tax credit depends on the nature of the credit, and certain types of tax credits are granted to individuals or businesses in specific locations, classifications or industries. Unlike deductions and exemptions, which reduce the amount of taxable income, tax credits reduce the actual amount of tax owed.

BREAKING DOWN 'Tax Credit'

Governments may grant a tax credit to promote a specific behavior, such as replacing older appliances with more efficient ones, or to help disadvantaged taxpayers by reducing the total cost of housing.

Tax credits are more favorable than tax deductions or exemptions, because tax credits reduce tax liability dollar for dollar. While a deduction or exemption still reduces the final tax liability, they only do so within an individual’s marginal tax rate. For example, an individual in a 15% tax bracket would save $0.15 for every marginal tax dollar deducted. However, a credit would reduce the tax liability by the full $1.

Nonrefundable Tax Credits

Nonrefundable tax credits are items directly deducted from the tax liability until the tax liability equals $0. Any excess nonrefundable tax credit is not utilized, as any amount that would potentially reduce the tax liability further is not paid out. Nonrefundable tax credits negatively impact low-income taxpayers, as they are often unable to utilize the entire amount of the credit. Nonrefundable tax credits are valid in the year of reporting only, expire after the return is filed, and may not be carried over to future years. As of 2016, specific examples of nonrefundable tax credits include benefits for adoption, raising children, earning foreign income, and paying mortgage interest.

Refundable Tax Credits

Refundable tax credits are the most beneficial credit, as they are entirely refundable. This indicates that, regardless of a taxpayer’s income or tax liability, he is entitled to the entire amount of the credit. This is true even if the refundable tax credit reduces the tax liability below $0, indicating the taxpayer is due a refund. As of 2016, the most common refundable tax credit is the Earned Income Tax Credit (EITC). Other refundable tax credits are available for education, health care coverage and for raising children.

Partially Refundable Tax Credits

Some tax credits are partially refundable, which can both decrease taxable income and lower tax liability. As of 2016, an example of a partially refundable tax credit is the American Opportunity Tax Credit. If a taxpayer reduces his tax liability to $0 before using the entire portion of the $2,500 tax deduction, 40% of remaining eligible credit may be taken as a refundable credit.

RELATED TERMS
  1. Refundable Credit

    A tax credit that is not limited by the amount of an individual's ...
  2. Non-Refundable Tax Credit

    A tax credit that can't reduce the amount of tax owed to less ...
  3. Tax Refund

    A tax refund is a refund on taxes paid to an individual or household ...
  4. Additional Child Tax Credit

    A refundable credit that can be claimed by taxpayers who are ...
  5. IRS Publication 514

    A document published by the Internal Revenue Service that provides ...
  6. Child Tax Credit

    A credit given to taxpayers for each dependent child that is ...
Related Articles
  1. Personal Finance

    What's IRS Form 1040 For?

    Most U.S. taxpayers will be familiar with the 1040. By the end of filling it out, you'll know how much tax you owe, or what your refund is.
  2. Personal Finance

    Tax Credits And Deductions For Parents

    Your children can help you save on your taxes with these credits and deductions.
  3. Personal Finance

    5 Tax Credits You Shouldn't Miss

    If you're not taking advantage of these deductions, you could be missing out on tax savings.
  4. Personal Finance

    Tax Credits That Can Get You a Refund

    Here are a few of the credits that may result in a refund check, even if you owe no taxes this year.
  5. Personal Finance

    Top Tax Refunds For Recent Grads

    Don't miss out on these tax credits if you have recently graduated.
  6. Personal Finance

    Get A Tax Credit For Your Foreign Investments

    The foreign tax credit provides a break on investment income made and taxed in a foreign country.
  7. Retirement

    5 Top Tax Season Questions

    A tax pro answers questions she hears most often and quashes some myths.
  8. Personal Finance

    How To Get The Most Money Back On Your Tax Return

    Many people pay more taxes than they have to simply because they don’t know better. Here are a few suggestions for getting the most out of your tax return.
  9. Personal Finance

    Understanding Taxation Of Foreign Investments

    Technically, any gains from foreign investments owned by an American citizen are subject to tax by the company's home country as well as the IRS. However, the Foreign Tax Credit enables you to ...
  10. Personal Finance

    What is a Tax Liability?

    Tax liability is the amount of money a person or entity owes to the government as the result of a taxable event.
RELATED FAQS
  1. What is the difference between a write-off and a deduction?

    Understand the differences between a tax write-off and a tax deduction. Learn how each one works to reduce income taxes and ... Read Answer >>
  2. What is the difference between a state income tax and a federal income tax?

    Learn the difference between state income tax and federal income tax based on tax rates, deductions, tax credits and taxable ... Read Answer >>
  3. What are some ways to minimize tax liability?

    Learn what tax strategies are available to individuals and business owners that may allow for a reduction in tax liability ... Read Answer >>
  4. How does the marginal tax rate system work?

    The marginal tax rate is the rate of tax that income earners incur on each additional dollar of income. As the marginal tax ... Read Answer >>
  5. How can I lower my effective tax rate without lowering my income?

    Discover how to reduce your effective tax rate without losing income by maximizing adjustments and deductions, earning tax-free ... Read Answer >>
  6. What assets are taxable and what assets are not taxable?

    Adjust your taxable income by understanding what assets the IRS taxes. Learn about legal strategies to lower tax liability ... Read Answer >>
Trading Center