Tax Credits

The word "tax credit" refers to a sum of money that taxpayers can deduct directly from their taxes. This is distinct from tax deductions, which reduce an individual's taxable income.

The worth of a tax credit is dependent on its type. Individuals or businesses in specified areas, classifications, or industries may be eligible for tax credits.

Understanding Tax Credits

Tax credits may be granted by the federal and state governments to encourage specific actions that help the economy, the environment, or anything else that the government deems significant.

For example, there is a tax credit available to consumers who install solar panels for household usage. Additional tax credits assist in defraying the costs of child and dependent care, education, and adoption.

Tax credits are preferable to tax deductions since they reduce taxable income dollar for dollar. While a deduction still decreases an individual's final tax liability, it only does so within the limits of their marginal tax rate.

A person in the 22% tax rate, for example, would save $0.22 for every dollar of marginal tax deducted. A credit, on the other hand, would lower the tax liability by the whole $1.

Example Of A Tax Credit

Assume you've done your calculations and discovered that you owe the government $2,000 in taxes for the year. However, your tax consultant contacts you to notify that you meet the criteria for a refundable tax credit of $2,500. This means that you will not only have no tax payment, but you will also receive a $500 refund.

If the tax credit had been nonrefundable, your financial advantage would have been restricted to the amount of taxes you owed. The remaining $500 of tax credit would not be refunded to you.

Types Of Tax Credits

There are three classifications of tax credits: nonrefundable, refundable, and partially refundable.

Nonrefundable Tax Credits

Nonrefundable tax credits are amounts deducted immediately from a person's tax liability until the tax due equals zero. Any sum in excess of the tax payable that would normally result in a refund for the taxpayer is not paid out as a refund. As a result, the phrase "nonrefundable" was coined. In effect, the remainder of a nonrefundable tax credit that cannot be used is forfeited.

Nonrefundable tax credits for the 2022 tax year include the following:

• Adoption credit
• Lifetime Learning Credit
• Residential energy credit
• Work opportunity credit
• Child and Dependent Care Credit
• Other dependents credit
• Retirement Savings Contributions Credit
• Child Tax Credit (CTC)
• Mortgage interest credit (helps lower-income taxpayers afford a home)

Refundable Tax Credits

Refundable tax credits are the most advantageous because they are paid in full. This means that a taxpayer (regardless of income or tax liability) is entitled to the full amount of the credit, even if they owe no taxes. For example, if the refundable tax credit reduces the taxpayer's tax burden to less than $0, the taxpayer is entitled to a refund of that amount.

Partially Refundable Tax Credits

Several tax breaks are only partially refundable. The American Opportunity Tax Credit (AOTC) for higher education students is one example. Suppose the taxpayer lowers their tax liability to zero before utilizing the full $2,500 tax deduction; in that case, they may claim the remaining amount as a refundable credit up to $1,000 or 40% of the residual credit, whichever is lower.