A tax credit is an amount of money that taxpayers can subtract directly from taxes owed to their government. Unlike deductions, which reduce the amount of taxable income, tax credits reduce the actual amount of tax owed. The value of a tax credit depends on the nature of the credit; certain types of tax credits are granted to individuals or businesses in specific locations, classifications, or industries.
Types of Tax Credits
Nonrefundable Tax Credits
Nonrefundable tax credits are items directly deducted from the tax liability until the tax due equals $0. Any amount greater than the tax owed, resulting in a refund for the taxpayer, is not paid out—hence, the name “nonrefundable.” The remaining part of a non-refundable tax credit that can’t be utilized is lost, in effect.
Nonrefundable tax credits are valid in the year of reporting only, expire after the return is filed, and may not be carried over to future years. Because of this, nonrefundable tax credits can negatively impact low-income taxpayers, as they are often unable to use the entire amount of the credit.
Examples of non-refundable tax credits include credits for adoption, the Lifetime Learning Credit, the Child and Dependent Care Credit, the Saver’s Tax Credit for funding retirement accounts.
Refundable Tax Credits
Refundable tax credits are the most beneficial credit because they are paid out in full. This means that taxpayers, regardless of their income or tax liability, are entitled to the entire amount of the credit. If the refundable tax credit reduces the tax liability to below $0, the taxpayer is due a refund.
Currently, the most popular refundable tax credit is the Earned Income Tax Credit (EITC). The EITC is for low to moderate-income taxpayers who earned an income, through an employer or working as a self-employed individual with a business or farm, and meet certain criteria based on income and number of family members. Other refundable tax credits include the Premium Tax Credit, which helps individuals and families cover the cost of premiums for health insurance purchased through the health insurance marketplace.
Partially Refundable Tax Credits
Some tax credits are only partially refundable. The Child Tax Credit became refundable (up to $1,400 per qualifying child) in 2018, as a result of the Tax Cuts and Jobs Act (TCJA). If a taxpayer has a large enough tax liability, the full amount of the Child Tax Credit is $2,000. However, up to $1,400 is refundable even if it is more than the taxpayer owes.
Another example of a partially refundable tax credit is the American Opportunity Tax Credit (AOTC) for post-secondary education students. If a taxpayer reduces their tax liability to $0 before using the entire portion of the $2,500 tax deduction, the remainder may be taken as a refundable credit up to the lesser of 40% of the remaining credit or $1,000.
KEY TAKEAWAYS
- A tax credit is an amount of money that taxpayers are permitted to subtract, dollar for dollar, from the income taxes that they owe.
- Tax credits are more favorable than tax deductions because they actually reduce the tax due, not just the amount of taxable income.
- There are three basic types of tax credits: nonrefundable, refundable, and partially refundable.
- A nonrefundable tax credit can reduce the tax you owe to zero, but it can’t provide you with a tax refund.