What is a Tax Credit? A Beginner's Guide
Tax credits can reduce the tax you owe dollar-for-dollar. But how do tax credits work, and how do you claim them? Learn more inside.
November 22, 2021
Tax season probably isn’t your favorite time of the year, but filing taxes is a necessary part of managing your finances. To reduce your taxes as much as possible, it pays to be knowledgeable about tax credits and deductions.
This guide will answer the question, “What is a tax credit?” as well as outline common tax credits and how they work. It’ll also clear up any confusion regarding the difference between a tax credit and a tax deduction.
What is a tax credit?
A tax credit is an amount of money that taxpayers may subtract from the federal income tax they owe.
Tax credits reduce taxes owed dollar-for-dollar. For example, a $1,000 tax credit would reduce your IRS tax liability by $1,000.
Tax credit examples include:
Lifetime Learning Credit and American Opportunity Tax Credit (which are both for higher education expenses)
Earned income tax credit (reserved for lower-income taxpayers)
Saver’s Tax Credit (reserved for lower-income taxpayers who save for retirement)
The child tax credit (reserved for families with children)
Many common tax credits are aimed at lower-income taxpayers. But some credits, like the child tax credit, are available to households with higher income levels. Each credit has a maximum income limit.
Keep in mind that tax credits only affect federal income tax. They won’t affect state income taxes or other federal taxes like Social Security tax.
Tax credit vs. tax deduction
Tax credits lower your tax owed dollar-for-dollar.
Tax deductions, on the other hand, only lower taxable income.
A $1,000 tax deduction would reduce your taxable income by $1,000. If you’re in the 22% tax bracket, this means that that $1,000 deduction would reduce your tax owed by $220.
Common deductions and credits can help you reduce your taxable income and tax owed — but credits have a bigger impact overall.
Examples of tax deductions include:
Student loan interest,
State income tax paid
Property tax paid
Mortgage interest paid and more.
How do tax credits work?
If you qualify for a tax credit, the credit can reduce your federal income tax due dollar-for-dollar.
The specifics will be calculated when you file your taxes (whether you use tax software or an accountant).
For example, if you owe $10,000 in federal income taxes but have two children ages 8 and 12, you may qualify for up to a $6,000 child tax credit ($3,000 per child over 6).
This would reduce your tax liability dollar-for-dollar, meaning you’d owe only $4,000 in federal income taxes instead of the full $10,000.
Types of tax credits
There are three types of tax credits:
Nonrefundable tax credits. Non-refundable credits reduce your tax liability until it hits $0. For example, if you owe $2,000 in federal income taxes but receive a credit of $3,000, your federal income tax liability would be entirely erased. However, you wouldn’t receive the remaining $1,000 credit as a tax refund.
Refundable tax credits. Refundable tax credits can reduce your income tax liability past $0, potentially resulting in a tax refund. In the same example above, the $3,000 credit would erase your tax liability and result in a bonus $1,000 tax refund.
Partially refundable tax credits. Partially refundable tax credits can reduce your tax liability past $0, potentially resulting in a tax refund. However, you won’t necessarily receive the full amount refunded. For example, the American Opportunity Credit for higher education expenses is worth up to $2,500 — but only up to the lesser of $1,000 or 40% of the remaining credit is refundable.
Common tax credits & how to claim them
There are many tax credits, but the most common ones come in three categories:
Below are some of the most common tax credits. For a complete list of available credits and deductions, consult the IRS.
Tax credits for families
The Child Tax Credit: Households with children can claim up to $3,600 for each child under 6 and $3,000 for each child over 6. The credit was recently expanded and can be sent in monthly installments instead of a tax refund in April.
Income limits: Single head of household filers with children can claim the full credit if they make up to $112,500. Couples filing jointly can claim the full credit with a combined income of up to $150,000.
Tax credits for education
American Opportunity Tax Credit (AOTC): If you have qualified higher education costs for undergraduate programs, this credit can lower your tax owed by up to $2,500. You can claim a credit for the entire amount of tuition, books and school fees you paid in a given tax year, up to $2,000. You can also claim 25% of the next $2,000, for a total of $2,500. So if you paid $4,000 or more in higher education costs, you can claim the full $2,500 credit.
Income limits: Taxpayers with a modified adjusted gross income (MAGI) of up to $80,000 ($160,000 for couples filing jointly) can claim the full amount of the AOTC credit. The credit phases out between $80,000 to $90,000, and isn’t available to those with a MAGI of over $90,000 (or $180,000 filing jointly)
Lifetime Learning Credit (LLC): If you have qualified education expenses, you can claim a credit of 20% of the first $10,000 in expenses paid, for a maximum credit of up to $2,000. The Lifetime Learning Credit can be used for graduate school and continuing education; there’s no limit to the number of years you can claim the credit.
Income limits: Taxpayers with a modified adjusted gross income (MAGI) of less than $59,000 ($118,000 if you filed jointly) can claim up to the full LLC credit. The credit is reduced for MAGI levels between $59,000 and $69,000 ($118,000 to $138,000 if you filed jointly) and is not available for those with a MAGI of more than $69,000 ($138,000 if you're married and filing jointly).
Tax credits for low-income households
Earned Income Tax Credit (EITC): Low-income taxpayers who complete paid work can claim the Earned Income Tax Credit. This credit provides workers with a credit equal to a percentage of their earnings, up to a maximum credit amount. The calculation is complex; more information can be found here.
Income limits: The income limits for the EITC depend on your tax filing status, number of dependents and other factors. You can use this IRS calculator to see if you may qualify for the EITC.
Saver’s Tax Credit: Low-income households that contribute to retirement plans such as a Roth IRA may qualify for the Saver’s Tax Credit. This credit is worth up to 10%, 20% or 50% of the amount you contribute to your retirement accounts. The credit amount depends on your income level and retirement contributions. The maximum credit is $1,000 for single filers or $2,000 for married couples filing jointly.
Income limits: Single filers with an AGI of over $33,000 cannot claim the credit. The limit is $66,000 for married couples filing jointly.
Tax credits reduce your tax owed dollar-for-dollar. Some are even refundable, meaning that they can increase the amount of your tax refund.
Understanding “What is a tax credit?” could lead to savings come tax season. These credits can be valuable, so it’s important to make sure that you claim any you’re eligible for.
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