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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.

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