What Are Tax Credits?

What is a tax credit?

Tax credits reduce the amount of income tax you owe to the federal and state governments. Credits are generally designed to encourage or reward certain types of behavior that are considered beneficial to the economy, the environment, or to further any other purpose the government deems important. In some cases, credits cover expenses you pay during the year and have requirements you must satisfy before you can claim them.

How do tax credits work?

A tax credit is a dollar-for-dollar reduction in your income. For example, if your total tax on your return is $1,000 but you are eligible for a $1,000 tax credit, your net liability drops to zero. Some credits, such as the Earned Income Credit, are refundable, which means that you still receive the full amount of the credit even if the credit exceeds your total tax bill. Therefore, if your total tax is $400 and you claim a $1,000 Earned Income Credit, you will receive a $600 refund.

Types of tax credits

There's an array of tax credits available to all types of taxpayers covering a wide range of expenses and situations. As an incentive for taxpayers to protect the environment, the federal government offers a credit for the cost of purchasing solar panels for use in your home.

To help families wanting to adopt a child, the federal adoption tax credit can reduce your tax bill to offset some of the costs you incur that are necessary to adopt a child. Other credits cover the expense of child and dependent care as well as education credits.

What’s the difference between a tax credit and a deduction?

Tax credits generally save you more in taxes than deductions. Deductions only reduce the amount of your income that is subject to tax, whereas, credits directly reduce your total tax. To illustrate, suppose your taxable income is $50,000 and you have $10,000 in deductions, which reduces your taxable income to $40,000. If that $10,000 would have been taxed at a rate of 25%, then the deduction saves you $2,500 in tax. If the $10,000 was a tax credit instead of a deduction, your tax savings is $10,000 rather than $2,500.

What’s the difference between a tax credit and a tax refund?

A tax refund is the reimbursement you receive from the federal and/or state government for any overpayment of taxes. 

When you file your yearly tax return, you’ll factor in things like your filing status, deductions, and tax credits, which can ultimately result in your tax burden being lower than what you paid in taxes during the year. If that’s the case, you should receive a tax refund. 

A tax credit is a dollar amount that you can subtract from your income tax to reduce your overall tax liability. So, while a tax refund simply represents the difference between the taxes you paid versus the taxes you actually owe, a tax credit is a benefit that directly reduces your tax burden. 

In some cases, you can qualify for refundable tax credits that will increase your tax return if they exceed your total tax liability. 

What are federal tax credits?

Tax credits are offered at both the federal and state level. Not every state requires residents to file income taxes, so some states don’t offer tax credits. When it comes to the federal government, on the other hand, most US citizens are required to file an income tax return.

Given that the majority of people have to navigate federal income tax, it’s crucial to understand what federal tax credits are if you want to minimize your tax burden. 

Federal tax credits are benefits that reduce the taxes you owe to the federal government. Examples of federal tax credits include:

• The Earned Income Credit (EIC)
• The Child and Dependent Care Credit 
• Eligible Individual Retirement Arrangement (IRA) contributions
• Education tax credits

Federal tax credits not only benefit individuals, but also businesses and business owners. For example, investors and businesses can claim tax credits when they invest in designated Opportunity Zones, which are distressed areas that can use funds to improve communities and promote economic activity.

What are state tax credits?

Many states that impose an income tax on residents often times offer tax credits. For example, if you live in California, you may qualify for a renter's credit if you pay rent for your housing, your income is below a certain amount, and you meet other state requirements. Many states also offer tax credits similar to federal credits. For example, many states and the District of Columbia offer credits that mirror the federal Earned Income Credit.

How do I know if I’m eligible for a tax credit?

There are many different types of tax credit that you could potentially qualify for. In addition to tax credits at the federal level, there are also state-level tax credits that will vary depending on the state you reside in. 

You can do some research online or visit the IRS website to find a list of tax credits and check whether or not you’re eligible for any of them. You can also work with a tax expert or use tax software like TurboTax to quickly and easily determine whether you qualify for any tax credits.

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