What Is Tax Credit: Definition & How to Claim It

KEY TAKEAWAYS

• A tax credit is a specific amount taxpayers can use to reduce the amount of income tax that they owe. This is done on a dollar-for-dollar basis.
• The three most common types of tax credits include refundable, nonrefundable, and partially refundable.
• Tax credits differ significantly from deductions since they reduce the amount of tax that’s actually due instead of taxable income.
• Nonrefundable tax credits won’t provide any type of tax refund, but they can reduce the amount of tax owed to zero.

What Are Tax Credits?

A tax credit is essentially a reduction of the income tax you owe and it’s calculated on a dollar-for-dollar basis. Essentially, a tax credit helps reduce the total amount of income tax you’ll have to pay back to both federal and state governments.

Many tax credits are designed with the purpose of encouraging and rewarding specific behaviors. These can include behaviors that benefit the environment, economy, or another government purpose.

There are certain requirements that you must meet first to be eligible for certain tax credits. But, in most cases, they’re meant to help cover a range of expenses you might incur throughout the year.

Tax credits may be refundable, partially refundable, or non-refundable. It is also worth noting that certain credits may be subject to phaseout.

Types of Tax Credits

There are an array of tax credits you could be eligible for, and they fall into three primary categories of tax credits. They include refundable tax credits, nonrefundable tax credits, and partially refundable tax credits. Let’s take a closer look at how each of them works. 

Refundable Tax Credits

Refundable tax credits are going to provide you with the most benefits. This is because, as the name suggests, they’re paid out in full. So, any individual taxpayer is eligible for the entire amount of the refundable tax credit.

Income and tax liability aren’t considered, and if the credit reduces tax liability to less than $0, then you will be entitled to a tax refund. One of the most popular types of refundable tax credits is the earned income tax credit (EITC). This is usually for lower to moderate-income taxpayers who meet certain criteria.

Another example of a refundable tax credit is the premium tax credit. This tax credit allows families and individuals to cover health insurance premium costs. These often get purchased through a health insurance marketplace.

Nonrefundable Tax Credits

Nonrefundable tax credits help reduce your tax liability to $0. Any credit amount that exceeds your income tax liability is lost – it won’t generate a tax refund. 

Some non refundable credits can only be claimed in the same year the tax is calculated. Others, such as the foreign tax credit, can be carried over to other years.

Some of the most common types of nonrefundable tax credits include:

• Lifetime Learning education credit
• Child and dependent care credit
• Retirement savings contribution credit
• Child tax credit
• Mortgage interest credit
• Adoption credit
• Foreign tax credit 

Partially Refundable Tax Credits

As you may guess, partially refundable tax credits tow the line between a refundable and nonrefundable tax credit: they’re only partially refundable. The best way to describe how partially refundable tax credits work is with the American Opportunity Tax Credit (AOTC).

This tax credit is only available to post-secondary education students. If they can reduce their total tax liability to zero before all the eligible credit is claimed, 40% of the remaining credit or up to $1,000 can get refunded.

How Tax Credits Work

A tax credit for taxpayers is a dollar reduction that helps reduce your total tax liability dollar-for-dollar. Depending on the type of tax credit you might be eligible for a full refund, a partial refund, or no refund at all. It all depends on the specific type of tax credit in question.

For example, you can receive the full amount of the earned income credit even if it exceeds your tax bill. So if you claimed $1,000 in earned income credit and your total tax was $400, you would be eligible for a $600 refund.

Comparing Tax Credits to Tax Deductions

In most cases, tax credits can provide more benefits and advantages compared to tax deductions. Deductions reduce your income amount that’s subject to your applicable tax rates. Tax credits, on the other hand, reduce the total amount of tax that you pay.

• Tax Credits: lower the amount of tax you owe
• Tax Deductions: lower your taxable income

Summary

A tax credit is a certain amount of money that individual taxpayers may be entitled to claim to reduce the amount of tax owed. The tax credits are subtracted from the tax liability, ultimately reducing the total amount of tax you owe or bringing it to zero.

Some criteria must be met to be eligible for certain tax credits. As well, the actual value of the tax credits can depend on the specific nature of the credit itself. Most tax credits can be put into three categories. These are refundable, nonrefundable, and partially refundable tax credits.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.