What Is a Tax Credit?
A tax credit is an amount of money that taxpayers can subtract from taxes owed to their government. Unlike deductions and exemptions, 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 or exemptions 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.
How Tax Credits Work
Governments may grant a tax credit to promote a specific behavior—such as replacing older appliances with more energy-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, 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
Tax credits come in three basic forms.
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 2019 tax year, specific examples of nonrefundable tax credits include credits for adoption, 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 home ownership.
If a refundable tax credit reduces the tax liability below $0, the taxpayer is due a refund.
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 2019 tax year, probably the most popular refundable tax credit is the Earned Income Tax Credit (EIC). 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.
Partially refundable tax credits
Some tax credits are partially refundable, which can both decrease taxable income and lower tax liability. The Child Tax Credit became refundable (up to $1,400 per qualifying child) in 2018. 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 credit or $1,000.