What Is a Tax Credit?
A tax credit is an amount of money that taxpayers can subtract directly from taxes owed to their government. Unlike deductions, which reduce the amount of taxable income, tax credits reduce the actual amount of tax owed. The value of a tax credit depends on the nature of the credit; certain types of tax credits are granted to individuals or businesses in specific locations, classifications, or industries.
- 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.
Understanding Tax Credits
Governments may grant a tax credit to promote a specific behavior such as replacing older appliances with more energy-efficient ones. Other tax credits are designed to help disadvantaged taxpayers by reducing the total cost of housing.
Tax credits are more favorable than tax deductions because tax credits reduce tax liability dollar for dollar. While a deduction still reduces the final tax liability, it only does so within an individual’s marginal tax rate. An individual in a 22% tax bracket, for example, would save $0.22 for every marginal tax dollar deducted. However, a credit would reduce the tax liability by the full $1.
Tax Deductions Vs. Tax Credits
Types of Tax Credits
Nonrefundable Tax Credits
Nonrefundable tax credits are items directly deducted from the tax liability until the tax due equals $0. Any amount greater than the tax owed, resulting in a refund for the taxpayer, is not paid out—hence, the name "nonrefundable." The remaining part of a nonrefundable tax credit that can't be utilized is lost, in effect.
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. Because of this, nonrefundable tax credits can negatively impact low-income taxpayers, as they are often unable to use the entire amount of the credit.
As of the 2020 tax year, specific examples of nonrefundable tax credits include credits for adoption, the Lifetime Learning Credit, the Child and Dependent Care Credit, the Saver's Tax Credit for funding retirement accounts, and the mortgage interest credit, which is designed to help people with lower incomes afford homeownership.
Refundable Tax Credits
Refundable tax credits are the most beneficial credit because they're paid out in full. This means that a taxpayer—regardless of their income or tax liability—is entitled to the entire amount of the credit. If the refundable tax credit reduces the tax liability to below $0, the taxpayer is due a refund.
As of the 2020 tax year, probably the most popular refundable tax credit is the Earned Income Tax Credit (EITC). The EITC is for low to moderate-income taxpayers who earned an income, through an employer or working as a self-employed individual with a business or farm, and meet certain criteria based on income and number of family members. Other refundable tax credits include the Premium Tax Credit, which helps individuals and families cover the cost of premiums for health insurance purchased through the health insurance marketplace.
Your first $1,200 ($2,400 for couples) stimulus payment, officially known as a "Recovery Rebate," is an advance refundable tax credit on 2020 taxes. This means no matter how much you owe (or don't owe) in taxes for the 2020 tax year, you get to keep all the money with no taxes due on it. The same is true of the second $600 stimulus checks signed into law on Dec. 27.
Partially Refundable Tax Credits
Some tax credits are only partially refundable. The Child Tax Credit became refundable (up to $1,400 per qualifying child) in 2018, as a result of the Tax Cuts and Jobs Act (TCJA). If a taxpayer has a large enough tax liability, the full amount of the Child Tax Credit is $2,000. However, up to $1,400 is refundable even if it is more than the taxpayer owes.
Another example of a partially refundable tax credit is the American Opportunity Tax Credit (AOTC) for post-secondary education students. If a taxpayer reduces their tax liability to $0 before using the entire portion of the $2,500 tax deduction, the remainder may be taken as a refundable credit up to the lesser of 40% of the remaining credit or $1,000.
Special Consideration: 2020 and 2021 Stimulus Payments
In 2020, as a result of the coronavirus pandemic and Coronavirus Aid, Relief, and Economic Security (CARES) Act stimulus bill, taxpayers received up to $1,200 per adult and $500 per child in the form of a stimulus check or direct deposit. The stimulus payment was an advance on a refundable tax credit for the 2020 tax year; the amount received will not add to taxable income in 2020 or any future year.
The same is true of the second $600 stimulus checks approved on Dec. 27, which provides $600 for qualifying individuals ($1,200 for qualifying couples) and $600 for qualifying children. The refundable tax credit for both checks phased out at an adjusted gross income (AGI) of $75,000 to $99,000 for singles (or $150,000 to $198,000 for joint taxpayers), at a rate of 5 percent per dollar. It was based on either the taxpayer's AGI for 2018 or 2019 (depending on whether the taxpayer had already filed a 2019 tax return by that point). But it technically applied to 2020 AGI (for which a return couldn't have been filed yet), so there may be some discrepancy.
- If it turns out the taxpayer's AGI for 2018 or 2019 (whichever one the IRS based the stimulus payment on), is lower than 2020, resulting in a higher payment, the taxpayer can keep the overage.
- If the taxpayer's AGI for 2018/19 is higher than in 2020, the taxpayer can claim the additional amount owed for both stimulus checks when filing 2020 taxes in 2021.
- This applies to dependents under 17 as well. If one taxpayer claimed a child, based on 2018/19 returns, but another taxpayer can legitimately claim that child on the 2020 tax return, the second taxpayer will get a $500 tax credit when filing a 2020 tax return and the person who received it based on 2018/19 returns will not have to pay it back.
- If a taxpayer has a child in 2020, they can claim the child when filing the 2020 tax return and receive the $500 credit then.
Finally, the recovery rebate is not taxable. It will not add to taxable income in 2020 (or any future year). All of this is based on the fact that the CARES Act contains no "claw back" mechanism by which the government can reclaim funds that were legitimately extended. The same is true of the Consolidated Appropriations Act that includes the new stimulus funding.
2021 American Rescue Plan Changes
In March of 2021, Congress passed the American Rescue Plan, which was signed into law by President Biden. Under the plan, eligible individuals would receive up to $1,400 in stimulus checks. In addition, certain temporary changes were made to the child tax credit for Married couples filing jointly with a modified adjusted gross income up to $150,000, heads of household with MAGI up to $112,5000, or single filers with MAGI up to $75,000:
- Originally capped at $2,000 per eligible dependent child, the credit is increased to $3,000 for children between (and inclusive of) the ages of 6 and 17 and $3,600 for children under six.
- The credit becomes fully refundable; previously, only $1,400 was refundable.
- The IRS may issue up to half of an eligible household’s credit as an advance disbursed between July and December 2021, using 2020 returns (or 2019 if 2020 is unavailable) to determine eligibility.
- The bill eliminates the minimum income requirement; previously, families earning less than $2,500 a year were ineligible and credits were calculated based on distance from that minimum at a rate of 15 cents per child for every dollar of income above $2,500.
Changes were also made to the EITC. Originally capped at $543 for childless households, the maximum earned income tax credit for those same households in 2021 is $1,502. The bill also expands eligibility for childless households. Previously, people under the age of 25 and over the age of 65 could not claim the credit. The upper limit has been eliminated and the lower limit has been reduced to 19 (i.e., anyone 19 or over without a child who meets income requirements can claim EITC).
Note a few exceptions: students between 19 and 24 with at least half a full-time course load are ineligible. Former foster children or youth experiencing homelessness can claim the credit as 18-year-olds. Finally, for single filers, the phaseout percentage is increased to 15.3% and phaseout amounts are increased to $11,610.
All of the measures above (including Child and Child/Dependent Care credits) are temporary. They have only been approved for 2021.
Two EITC changes below, however, are permanent:
- People who otherwise would be eligible for the EITC but whose children do not have Social Security numbers will be permitted to claim the version of the credit meant for childless households.
- The investment income limit for 2021 has been raised from $3,650 or less to $10,000 or less. This $10,000 figure will be pegged to inflation and adjusted accordingly every year going forward.