How Does a Tax Credit Work to Reduce Your Taxes?
A tax credit reduces your tax liability dollar-for-dollar, providing a greater financial benefit than a deduction and potentially increasing your refund.
A tax credit is a financial tool that reduces the amount of income tax you are required to pay. When you qualify for a credit, you subtract its full value directly from the taxes you owe, providing a dollar-for-dollar reduction in your tax liability. For instance, if your tax liability is $4,000 and you are eligible for a $1,000 tax credit, your final tax bill is reduced to $3,000. This direct offset lowers the payment you must make to the government or increases the refund you receive.
Tax Credits vs. Tax Deductions
It is useful to contrast a tax credit with a tax deduction. A deduction reduces your taxable income, not your tax liability. Using the same scenario, a $1,000 deduction for someone in the 22% tax bracket would result in a tax savings of only $220. The value of a deduction depends on your tax bracket, while a credit’s value is constant regardless of your income level.
Types of Tax Credits
Tax credits are categorized into two primary types: nonrefundable and refundable. A nonrefundable tax credit can lower your tax liability, but only to zero. If the credit is larger than the amount of tax you owe, you do not receive the leftover amount as a refund. The excess value of the credit is simply lost.
For example, imagine your calculated tax liability is $800, and you qualify for a $1,000 nonrefundable credit. The credit will eliminate your entire $800 tax bill, reducing it to $0. However, the remaining $200 of the credit does not get paid to you and cannot be used further.
A refundable tax credit, on the other hand, can also reduce your tax liability to zero, but any excess credit amount is paid out to you as a tax refund. Using a similar example, if your tax liability is $800 and you qualify for a $1,000 refundable credit, your tax bill is first reduced to $0. The remaining $200 of the credit is then issued to you as part of your tax refund, resulting in a direct payment.
Common Examples of Tax Credits
Several well-known federal tax credits illustrate these concepts. The Child Tax Credit is designed to assist families with the costs of raising children and is partially refundable. For the 2024 tax year, up to $1,700 of the $2,000 per child credit may be refundable for eligible taxpayers. This means a portion can be paid out even if no tax is owed.
The American Opportunity Tax Credit helps with higher education expenses and is also partially refundable. It allows taxpayers to receive 40% of the credit, up to $1,000, as a refund. In contrast, the Credit for Other Dependents, which applies to qualifying dependents who are not eligible for the Child Tax Credit, is a nonrefundable credit. This means it can only reduce tax liability to zero and no portion is paid out as a refund. Another example is the Earned Income Tax Credit (EITC), which is a fully refundable credit designed for low- to moderate-income working individuals and couples.
How to Claim a Tax Credit
Claiming a tax credit involves a specific procedural path that begins with confirming your eligibility. The Internal Revenue Service (IRS) provides detailed rules and criteria for each credit, outlining income limitations, qualifying expenses, and other requirements. You must carefully review these instructions, typically found on the IRS website or in tax form instructions, to ensure you meet all the necessary conditions before proceeding.
Once eligibility is confirmed, the next step is to complete the specific IRS form or schedule associated with that credit. For instance, education credits are calculated on Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits). This form guides you through the calculation of the exact credit amount based on your qualified expenses and any income-based limitations. Proper documentation of the expenses used to claim the credit, such as tuition statements or receipts, should be retained for your records.
After calculating the credit amount on its designated form, you transfer that final figure to the main tax return, Form 1040, U.S. Individual Income Tax Return. The credit is entered on the appropriate line in the “Tax and Credits” section of the 1040. This final step integrates the credit into your overall tax calculation, directly reducing your tax liability or contributing to your refund.