Tax Credit: What It Is, How It Works, What Qualifies, 3 Types

What Is a Tax Credit?

A tax credit is an amount of money that taxpayers can subtract directly from the taxes they owe. Unlike deductions, which lower 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.

Key Takeaways

  • A tax credit is an amount of money that taxpayers can subtract, dollar for dollar, from the income taxes they owe.
  • Tax credits are more favorable than tax deductions because they 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.

Tax Deductions Vs. Tax Credits

Understanding Tax Credits

Federal and state governments may grant tax credits to promote specific behaviors that benefit the economy, the environment, or anything else the government deems important. For example, a tax credit is available that rewards people for installing solar panels for home use. Other tax credits help offset the costs of child and dependent care, education, and adoption.

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.

Types of Tax Credits

There are three categories of tax credits: nonrefundable, refundable, and partially refundable.

Nonrefundable tax credits

Nonrefundable tax credits are items directly deducted from 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 2021 tax year, specific examples of nonrefundable tax credits include the adoption credit, education credit, child and dependent care credit, retirement savings contribution credit, child tax credit, 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 2021 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 earn income through an employer or by working as a self-employed individual 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.

Partially refundable tax credits

Some tax credits are only partially refundable.

One example 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. 

Another example was the child tax credit, which 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 had a large enough tax liability, the full amount of the child tax credit was $2,000. However, up to $1,400 was refundable even if it was more than the taxpayer owed. Important: For tax years 2020 and 2021, this credit increased and became fully refundable as part of the American Rescue Plan (see below).

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 did not add to taxable income in 2020 or any future year.

The same was true of the second $600 stimulus check approved on Dec. 27, 2020, which provided $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% per dollar.

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 "clawback" 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 child tax 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 the 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 youths 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:

  1. 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.
  2. 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.

What Are the Three Types of Tax Credits?

Tax credits can be nonrefundable, refundable, or partially refundable. Refundable tax credits are the most beneficial because they can reduce tax liability to below $0, in which case the taxpayer would receive a refund.

How Much Is a Tax Credit Worth?

Tax credits reduce the amount of tax you owe, dollar for dollar. The amount of the credit depends on the type of credit you qualify for and other factors like your filing status and income.

What Is the Difference Between a Tax Credit and a Tax Deduction?

Tax credits directly lower the amount of tax you owe, while tax deductions lower your taxable income. For example, a tax credit of $1,000 lowers your tax bill by that same $1,000. On the other hand, a $1,000 tax deduction lowers your taxable income (the amount of income on which you owe taxes) by $1,000. So, if you fall into the 22% tax bracket, a $1,000 deduction would save you $220.

Article Sources
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  2. Internal Revenue Service. "Publication 17, Your Federal Income Tax." Accessed Jan. 27, 2022.

  3. Internal Revenue Service. "Earned Income Tax Credit (EITC)." Accessed Jan. 27, 2022.

  4. Internal Revenue Service. "The Premium Tax Credit - The Basics." Accessed Jan. 27, 2022.

  5. Internal Revenue Service. "American Opportunity Tax Credit." Accessed Jan. 27, 2022.

  6. Internal Revenue Service. "Publication 972, Child Tax Credit and Credit for Other Dependents," Page 8. Accessed Jan. 27, 2022.

  7. U.S. Congress. "H.R.748 - CARES Act." Accessed Jan. 27, 2022.

  8. Internal Revenue Service. "Treasury and IRS Begin Delivering Second Round of Economic Impact Payments to Millions of Americans." Accessed Jan. 27, 2022.

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  11. U.S. Congress. "H.R. 133, Consolidated Appropriations Act, 2021." Accessed Jan. 27, 2022.

  12. U.S. Congress. "American Rescue Plan of 2021." Accessed Jan. 27, 2022.

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