What is a Tax Credit?
A tax credit is an amount of money that taxpayers can subtract from taxes owed to their government. 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. Unlike deductions and exemptions, which reduce the amount of taxable income, tax credits reduce the actual amount of tax owed.
Tax Deductions Vs. Tax Credits
Why Tax Credits Are Favored
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 22% tax bracket would save $0.22 for every marginal tax dollar deducted. However, a credit would reduce the tax liability by the full $1.
Types of Tax Credits
Tax credits come in a variety of forms, depending on tax regulations.
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 (by giving the taxpayer a refund, for example), as any amount that would potentially reduce the tax liability further is not paid out.
Unlike a tax deduction, a tax credit reduces the amount of taxes that you owe, dollar for dollar.
Nonrefundable tax credits negatively impact low-income taxpayers, as they are often unable to use 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 tax year 2018, specific examples of nonrefundable tax credits include credits for adoption, non-child dependents, paying foreign taxes, and the mortgage interest credit.
Refundable Tax Credits
Refundable tax credits are the most beneficial credit, as they are entirely refundable. This means that—regardless of a taxpayer’s income or tax liability—they are entitled to the entire amount of the credit. This is true even if the refundable tax credit reduces the tax liability below $0. In that situation, the taxpayer is due a refund. As of tax year 2018, probably the most popular refundable tax credit is the Earned Income Tax Credit (EITC). The Child Tax Credit became refundable (up to $1,400 per qualifying child) in 2018. Other refundable tax credits are available for education and healthcare coverage.
Partially Refundable Tax Credits
Some tax credits are partially refundable, which can both decrease taxable income and lower tax liability. An example of a partially refundable tax credit is the American Opportunity Tax Credit, which remains in place from 2018 on under the new tax legislation. 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.