Tax credits: Everything you need to know

Tax credits: Everything you need to know

02.12.2024

Tax credits reduce the amount you owe in taxes. The government typically creates credits to provide support for certain types of situations.

Tax credits may help reduce the amount you owe in taxes. The government typically creates credits to provide support for certain types of situations.

What are tax credits?

A tax credit is a dollar-for-dollar amount taxpayers claim on their tax return to reduce the income tax they owe. For example, if you owe $1,000 in federal income taxes but qualify for a tax credit of $500, you will only owe $500 after applying the credit.

Tax credits provide support for certain types of situations. For example, you may qualify for a federal tax credit for making certain energy saving improvements or energy efficient improvements to your home. This credit is intended to encourage taxpayers to make eco-friendly investments in their homes.

The difference between tax credits and deductions

It’s easy to confuse tax credits and deductions, but they aren’t the same thing. Tax credits are a dollar-for-dollar reduction of either your tax liability or are applied to offset a tax liability you may have. Tax deductions, on the other hand, generally reduce taxable income. That, in turn, can reduce your tax bill, though a reduction may not be as beneficial as a tax credit.

The good news is that you can use tax credits and tax deductions together to help decrease your tax burden. For example, you can apply relevant tax deductions to reduce your taxable income. That means you pay taxes on a smaller amount of your income. In some cases, you might even be able to use deductions to drop into a lower tax bracket to reduce your tax bill even further.

There are adjustments separate from deductions that will take you from gross income to adjusted gross income (AGI). This is important as AGI (or a modification thereof) is frequently referenced in tax code as a trigger or basis of limitation for, among other provisions, IRA contributions, Medicare premium surcharges or Affordable Care Act premium subsidies.

Here’s a general high-level formula for how the various pieces work together:

gross income +/- adjustments = adjusted gross income (AGI) – deductions = taxable income x tax rate(s) = tax liability – tax credits

Read more: How to calculate your adjusted gross income

How do tax credits work?

While there are different types of tax credits, they all work basically the same way when it comes to reducing your tax bill. It’s important to read the fine print on any tax credit opportunity or talk to a tax preparation professional to help maximize your credits when possible. However, in general, tax credits work as follows:

  • You must be eligible for the credit. Every tax credit has different requirements. For example, the Child Tax Credit requires that you have a dependent child with a Social Security Number. The child must generally be under age 17, have lived with you for at least half the year, and rely on you for at least half their financial support. You must be the only person claiming the child, as the child tax credit is only good once per year for each Social Security number.  Finally, eligibility for claiming the credit is limited or eliminated when your income exceeds certain levels. Tax professionals can help you determine your eligibility for tax credits. DIY tax preparation programs often prompt you for information about tax credits and use your feedback to match you up with potential tax credits.
  • You must claim the credit. You typically must do something specific on your tax return to claim a tax credit — you can’t simply assume the government knows you’re eligible and will provide the credit. Sometimes, a tax credit is triggered when you provide specific information. For example, if you include your dependent children and their Social Security Numbers on your tax return, that triggers the child tax credit calculation. You may also have to complete additional forms with the information necessary to claim the credit. Tax preparation tools generally populate the forms and include them in your return if the data you’ve provided, and your situation meet eligibility requirements.
  • The credit is applied to your outstanding tax liability. Tax credits will generally offset your tax liability or the balance you may owe with your tax return.  If you’re completing your tax return manually on paper, you may need to complete a worksheet to determine what tax you owe (or the amount of refund you are due) after applying credits you are eligible for. If you’re doing taxes yourself via tax preparation tools, those resources generally perform the calculations for you, but you must still verify and validate the results. Obviously, the same is true with a professional tax preparer as well.

The 3 types of tax credits

There are three main categories of tax credits: nonrefundable, refundable, and partially refundable. They all follow the same basic rules described above but differ slightly in how they impact your refund.

Nonrefundable tax credits

Nonrefundable tax credits can offset your tax liability. However, they are only applied to bring your tax liability lower or to zero. They cannot be applied to create a negative amount that would result in a refund of the remaining tax credit amount.

For example, say you calculate a $1,000 tax liability and have a nonrefundable tax credit of $800. Since $1,000 minus $800 equals $200, you would now only have a $200 tax liability remaining.

Now, say you calculated a $1,000 tax liability and can claim $1,000 in nonrefundable tax credits. That zeroes out your tax liability, and you wouldn’t owe any tax.

Finally, consider a situation where you calculate a $1,000 in tax liability, and you’re eligible for nonrefundable tax credits in the amount of $1,200. We know that $1,000 minus $1,200 is -$200. However, in this case, the tax credit is not refundable, so that extra $200 of additional tax credit doesn’t get refunded or go anywhere else on your tax return. Your tax liability is simply zeroed out, and you don’t owe any tax.

What if you don’t calculate any tax liability? If your tax liability is already zero, a nonrefundable tax credit doesn’t benefit you. It can only benefit you if you have tax liability to offset.

Some common nonrefundable tax credits include, but aren’t limited to:

  • Lifetime learning credit. This credit is up to $2,0001 per year for eligible students enrolled in and paying for qualifying degree courses. That includes many undergrad, graduate-level, and professional-level courses.
  • Saver’s credit. You may be able to claim the Saver’s credit if you are making voluntary contributions to a 401k or other qualified, tax-deferred fund and your adjusted gross income is below a certain threshold.
  • Foreign tax credit. If you’re a U.S. citizen who receives income from foreign sources and pays income or withholding taxes to foreign governments on that income, you may qualify for this credit.
  • Energy tax credit. The federal government offers a few energy tax credits that you may be able to claim if you’ve made energy-efficient upgrades to your home.
  • Electric vehicle tax credit. This credit is offered to taxpayers who purchase qualifying electric vehicles or plug-in hybrid vehicles. In 2024, People who buy new electric vehicles may be eligible for a tax credit as high as $7,5002.

Refundable tax credits

Refundable tax credits do more than reduce the amount of taxes you owe. They can  trigger a refund of up to the full amount of the tax credit under certain circumstances.

Unlike what happens with nonrefundable tax credits, when  a refundable tax credit exceeds the tax liability, that difference is refunded to you.

For example, say you calculate a $500 tax liability and qualify for $700 in refundable tax credits. That leads to a $200 excess refundable tax credit. You get that $200 as a refund.

What if you’re already getting a refund? In that case, a refundable tax credit increases how much you get back. Here are some hypothetical scenarios to help you see how this might work:

  • You calculate a $0 tax liability and have a $300 refundable tax credit. You get a refund of $300.
  • You have calculated a refund of $500 already and have a $200 refundable tax credit on top of that. In this case, you’d get a refund of $700.

The most common example of a refundable tax credit is probably the Earned Income Credit. This credit is available for those who have earned income during the year and whose investment income and Earned Income fall below certain thresholds. The purpose of the Earned Income Credit is to supplement incomes for low-wage earners and help offset the burden associated with Social Security taxes for those individuals.

Read more: Exploring the earned income tax credit (EITC)

Partially refundable tax credits

Partially refundable tax credits take a hybrid approach between nonrefundable and refundable. These

tax credits reduce your calculated tax liability, just like any other tax credits. But they may also increase your refund amount by a percentage of the credit.

For example, say there’s a tax credit that is 30% refundable and provides an opportunity for up to $1,000 of credit. Now, imagine you have zero tax liability, and you qualify for the entire credit amount. Since 30% is refundable, that’s $300. You would get back $300 as a refund.

Here’s another hypothetical example using the same 30% refundable credit. Say you qualify for all $1,000 of the credit, and you calculate $800 in tax liability. That $800 minus $1,000 is -$200 in excess tax credit. Since the $200 is less than that 30% refundable amount, you would get all $200 back as refundable.

However, what if you only calculated $200 in tax liability in this case? The $200 tax liability minus the $1,000 in credit is -$800. However, only $300 of the credit is refundable, so you would only get back $300.

One example of a partially refundable tax credit is the American Opportunity Tax Credit (AOTC), which is available for up to $2,500 for qualifying students. This credit is 40% refundable, which means there’s an

opportunity to increase your refund by as much as $1,000. To qualify for the AOTC, you or your dependent must generally be seeking a degree, be enrolled in undergraduate studies, have no felony drug convictions, and be enrolled at least half-time.  Eligibility is limited or eliminated if your income exceeds certain levels. You can claim the AOTC for a maximum of 4 tax years.

Our take

Reducing your tax bill is possible, and you can do so thanks to deductions and tax credits. Learning more about your tax situation and how you can manage your income throughout the year to reduce your tax burden can also be important. Contributing to pre-tax savings accounts for retirement, for example, can help you save on your tax bill each year.

Overall, a great way to save money on your taxes – and everything else – is to understand how to manage your finances efficiently. You may want to consider meeting with a tax preparation professional to help maximize your tax credits where possible.

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1 IRS. “Lifetime Learning Credit.” January 2024.

2 IRS. “Credits for new clean vehicles purchased in 2023 or after.” January 2024.

RO3352570-0124

Glossary Label
Tax credit
Glossary Definition
A tax credit is a dollar-for-dollar amount taxpayers claim on their tax return to reduce the income tax they owe. The government typically creates credits to encourage certain behavior among citizens or to provide support for certain types of situations.
Gregory J. King, CPA

Gregory J. King, CPA

Contributor

Greg King is a Certified Public Accountant. Prior to his work as a Tax Specialist with Empower, Greg has worked in public accounting, primarily with individual and small business tax clients. Greg has also worked in various tax compliance roles within the financial services industry and as a financial planner.  Greg holds a BA in Accounting from the University of Louisville.

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