Tax credits decrease the amount of income tax you owe to the federal and state governments. Credits are usually designed to reward or encourage specific types of behavior that are considered promising to the economy, the environment, or any other purpose the government assumes essential.
In other words, a tax credit is a tax incentive that allows certain taxpayers to subtract the amount of the credit they have accrued from the total they owe the state. Moreover, it can be a credit granted in recognition of taxes already paid or a form of state support.
However, in most cases, credits cover expenses you pay during the year and have requirements you must satisfy before claiming them.
What are Tax Credits?
A tax credit is the amount of money that taxpayers subtract directly from taxed owed to the government. In contrast to deductions, which reduce taxable income, tax credits reduce the actual amount of tax owed.
Besides, the value of a tax credit depends on the nature of the credit. Also, certain tax credits are granted to individuals or businesses in specific locations, industries, or classifications.
How do Tax Credits Work?
A tax credit is a dollar-for-dollar reduction of the income tax you owe. For instance, if you owe $1,000 in federal taxes but are also eligible for a $1,000 tax credit, your net liability drops to zero.
Further, some credits, such as the earned income credit, are refundable, which means you will still receive the total credit amount even if the credit exceeds your total tax bill. Consequently, if your total tax is $400 and claims a $1,000 earned income credit, you will receive $600 as the final refund.
Understanding Tax Credits
The government may award a tax credit to encourage a particular behavior, such as replacing older appliances with more energy-efficient ones. Other tax credits help disadvantaged taxpayers by deducting the total cost of housing.
Tax credits are better than tax deductions because tax credits reduce tax liability dollar for dollar. Although a deduction reduces the final tax liability, it only does so within an individual’s marginal tax rate.
For instance, an individual in a 22% tax bracket would save around $0.22 for every marginal tax dollar deducted. Nevertheless, a credit would reduce the tax liability by the full $1.
Comparing Tax Credits to Tax Deductions
Tax credits usually save you more in taxes than deductions. Deductions can only reduce the amount of your income that is subject to tax; on the other hand, credits directly reduce your total tax.
For instance, suppose your taxable income is $50,000, and you have $10,000 in deductions which reduces your overall taxable income to $40,000. If you had to pay tax at the rate of 25% for $10,000, then the deduction saves you $2,500 in tax.
Now, if that $10,000 was a tax credit rather than a deduction, your tax savings is $10,000 instead of $2,500.
Types of Tax Credits
Tax credits come in three basic forms.
Non-refundable tax credits are directly deducted from the tax liability until the tax due equals $0.1. Further, any amount greater than the tax owed resulting in a refund for the taxpayer is not paid. The remaining part of a non-refundable tax credit that you cannot utilize is lost.
Non-refundable tax credits are valid only in the year of reporting. Moreover, they expire after the return is filed and cannot carry over to future years. Due to this, non-refundable tax credits can adversely impact low-income taxpayers, as they cannot use the entire credit amount.
Refundable tax credits are the most profitable credit because they are paid out in full. This means that a taxpayer, regardless of his/her income or tax liability, is entitled to the entire credit amount. In case the refundable tax credit reduces the tax liability to below $0, the taxpayer is due a refund.
As of the 2020 tax year, the most common refundable tax credit is the Earned Income Tax Credit (EITC). The EITC is for low to moderate-income taxpayers who earned an income by working as a self-employed individual with a business or farm.
Other refundable tax credits include Premium Tax Credit. This helps individuals and families cover the cost of premiums for health insurance purchased.
Partially Refundable Tax Credits
Some credits are only partially refundable. The Child Tax Credit became refundable in 2018 due to the Tax Cuts and Jobs Act. If the tax liability is large enough, the total amount of the Child Tax Credit is $2,000. But only up to $1,400 is refundable even if it is more than what the taxpayer owes.
Another illustration of a partially refundable tax credit is the American Opportunity Tax Credit for post-secondary education students. Suppose a taxpayer reduces his/her tax liability to $0 before using the entire portion of the $2,500 tax deduction. In that case, you may take the rest as a refundable credit up to the lesser 40% of the remaining credit or $1,000.
In 2020, taxpayers received up to $1,200 (Adult) and $500 (Child) in the form of a stimulus check or direct deposit as a result of the COVID-19 pandemic and Coronavirus Aid, Relief, and Economic Security Act (CARES) stimulus bill.
The stimulus payment was an advance on a refundable tax credit for the 2020 tax year. Moreover, the amount received will not add to taxable income in 2020 or any future year.
The same stands true for the second $600 stimulus check approved on 27th December, which provides $600 for qualifying individuals ($1,200 for eligible couples) and $600 for eligible children. The refundable tax credit for both checks phased out at an adjusted gross income of $75,000 to $99,000 for singles and $150,000 to $198,000 for joint fillers, at a rate of 5% per dollar.
This is just a brief look at what tax credits are. Since they come with limitations and a whole set of rules, it is prudent to consult a professional tax company near you before filing returns to help navigate the ones you qualify for.