In the corporate world, the only number that really matters at the end of the day is the bottom line. For taxpayers, the bottom-line number on their tax returns is just as important. There are three main components that determine this number: income, deductions, and credits.
After these first two components have been computed and all deductions subtracted from income, any remaining income is assessed the appropriate amount of tax. But this final number is not the bottom line for many taxpayers, because their actual tax liability can be reduced further dollar-for-dollar by the various tax credits to which they may be entitled.
- A tax credit is an amount of money that taxpayers are permitted to subtract, dollar for dollar, from the income taxes that they owe.
- Tax credits are more favorable than tax deductions because they actually reduce the tax due, not just the amount of taxable income.
- There are three basic types of tax credits: nonrefundable, refundable, and partially refundable.
- A nonrefundable tax credit can reduce the tax you owe to zero, but it can't provide you with a tax refund.
What Are Tax Credits?
Tax credits are dollar-for-dollar reductions in the amount of tax that you owe to the government. These credits are much more effective at reducing your tax than deductions, because deductions only reduce the amount of taxable income that will be assessed, while tax credits reduce your tax liability.
Tax credits fall into two main categories: refundable and non-refundable. Refundable credits pay back the excess difference to the taxpayer as a refund if the amount of the credit exceeds the total amount of tax that is owed. Non-refundable credits can only be credited against your tax liability for that tax year; any excess amount is lost.
For example, if you owe $1,500 in tax but have a tax credit of $2,000, then you will get a refund of $500 if the credit is refundable and nothing if it is non-refundable. As with deductions, most tax credits have an income threshold phase-out schedule that reduces and eventually eliminates eligibility for the credits for high-income taxpayers.
Refundable Tax Credits
Here are two examples of available refundable tax credits. They are:
- Earned Income Credit (EIC): The earned income credit (EIC) is designed to provide a tax incentive for low- and middle-income wage earners. The amount depends on the taxpayer's income level and number of dependents.
- Excess Social Security Tax and Tier 1 RRTA Tax Withheld Credit: This credit applies to taxpayers who have more than one employer and have the full amount of Social Security tax withheld by each employer. If the aggregate amount of Social Security tax exceeds the taxpayer's taxable wage base, then the excess amount withheld will be refunded to the taxpayer. The tax credit is also for railroad employees who paid too much into their tier 1 railroad employee retirement (RRTA).
Non-Refundable Tax Credits
There are quite a few tax credits that fall into the non-refundable category. Some are more common than others, and they differ in amount and complexity. Many of these credits are offered as tax incentives for certain types of activities, such as higher education and adopting a child.
Here is a breakdown of the major non-refundable credits:
- Hope Credit, American Opportunity Credit, and the Lifetime Learning Credit: The Hope credit and lifetime learning credit provide a measure of tuition reimbursement for parents (or students) who are paying college tuition and fees.
- Foreign Tax Credit: This credit is designed to reimburse taxpayers for the taxes they pay to foreign governments on investment income realized outside the U.S.
- Adoption Credit: The adoption credit allows taxpayers who adopt children to recoup some or all of the costs of the adoption process (which can be very expensive).
- Elderly or Disabled Credit: Taxpayers over age 65 and those who meet the Internal Revenue Service's (IRS) criteria for permanent and total disability are allotted a special credit. Taxpayers must meet income requirements to qualify.
- Dependent Care Credit: The dependent care credit helps taxpayers defray the costs of paying for childcare services, as long as certain conditions are met. To see the full list of conditions, see the child and dependent care credit page on the IRS website.
- Retirement Saving Contributions Tax Credit: The saver's tax credit is designed to encourage taxpayers who meet income restrictions to save for retirement by providing a reimbursement for their IRA or qualified plan contributions of up to $1000 for an individual or $2,000 for a married couple filing jointly.
- Miscellaneous Credits: An assortment of less-common tax credits exist that a smaller number of taxpayers qualify for, such as:
- Residential Energy Credit
- Qualified Plug-In and Electric Vehicle Credit
- Mortgage Interest Credit
- Health Coverage Credit
- Prior Year Minimum Tax: Individuals, Estates, and Trusts Credit
- Credit for Tax on Undistributed Mutual Fund Capital Gains
If you think your situation calls for the use of any of these credits, check the IRS website for further information.
The Bottom Line
There are a great many rules and provisions regarding the eligibility and limitations of the various tax credits that are available. Make sure that you use every available tool to help keep your hard-earned dollars where they belong (in your wallet).