Tax Credits Explained: Definition, Mechanism, Eligibility & 3 Main Types

Andy Smith, a Certified Financial Planner (CFP®), licensed realtor, and educator, brings over 35 years of extensive experience in personal finance, corporate finance, and real estate, helping thousands achieve their financial goals.

What Exactly Is a Tax Credit?

A tax credit is a specific dollar amount that taxpayers can subtract directly from the total income taxes they owe, unlike tax deductions which only reduce taxable income.

The value of a tax credit varies depending on its type and eligibility criteria, often targeted to individuals or businesses based on location, industry, or classification.

Key Points to Remember

• Tax credits reduce your tax bill dollar for dollar, making them more advantageous than deductions.
• There are three primary categories: nonrefundable, refundable, and partially refundable credits.
• Nonrefundable credits can lower your tax liability to zero but don’t result in a refund.
• Refundable credits can generate a refund if the credit exceeds your tax owed.

How Tax Credits Work

Governments at federal and state levels offer tax credits to encourage behaviors that benefit the economy, environment, or social welfare.

Examples include credits for installing solar panels, child and dependent care expenses, education costs, and adoption fees.

Tax credits provide a direct reduction in tax liability, unlike deductions which reduce taxable income and depend on your tax bracket. For instance, a person in the 22% tax bracket saves only 22 cents per dollar deducted, but a $1 tax credit reduces tax owed by a full dollar.

Types of Tax Credits

Tax credits fall into three categories: nonrefundable, refundable, and partially refundable.

Nonrefundable Tax Credits

These credits lower your tax owed to zero but do not provide a refund if the credit exceeds your tax liability. Any unused portion is lost and cannot be carried forward.

Nonrefundable credits apply only to the tax year claimed and may disadvantage low-income taxpayers who cannot fully utilize them.

Examples for the 2024 tax year include:

• 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 (for lower-income homeowners)

Refundable Tax Credits

Refundable credits are highly valuable as they can reduce your tax bill below zero, resulting in a refund of the excess amount.

The Earned Income Tax Credit (EITC) is a popular refundable credit for low- to moderate-income workers meeting income and family size criteria.

The Premium Tax Credit also helps families afford health insurance premiums purchased through marketplaces.

Partially Refundable Tax Credits

Some credits are only partially refundable. For example, the American Opportunity Tax Credit (AOTC) for higher education allows up to 40% of the remaining credit (up to $1,000) to be refundable.

The Child Tax Credit transitioned from nonrefundable to partially refundable (up to $1,700 in 2024 and 2025) following the Tax Cuts and Jobs Act.

During 2020 and 2021, it was fully refundable under the American Rescue Plan.

Impact of the 2021 American Rescue Plan

Signed into law in March 2021, the American Rescue Plan introduced stimulus payments and temporary expansions to tax credits.

Changes included increasing the Child Tax Credit to $3,000 for children 6 to 17 and $3,600 for those under 6, making it fully refundable, and advancing half of the credit in 2021.

The plan also removed income thresholds for eligibility and expanded the Earned Income Tax Credit for childless workers, lowering the age limit to 19 and removing the upper age cap.

Permanent changes include allowing taxpayers with children lacking Social Security numbers to claim the childless EITC and raising the investment income limit to $10,000 (indexed for inflation).

Note

Most of these provisions were temporary and reverted to prior rules for 2022 and beyond.

Tax Credit Example

If you owe $2,000 in taxes but qualify for a $2,500 refundable tax credit, your tax liability drops to zero and you receive a $500 refund.

If the credit were nonrefundable, your tax would be zero but you would not receive a refund for the remaining $500.

Popular Tax Credits

Child and Dependent Care Credit

For 2024, this nonrefundable credit helps offset costs for care of children under 13 or dependents who cannot care for themselves, allowing up to $3,000 for one dependent or $6,000 for two or more.

The credit percentage ranges from 20% to 35% based on income and requires IRS Form 2441.

Lifetime Learning Credit

This credit covers 20% of up to $10,000 in qualified education expenses, up to $2,000 per tax return, for any postsecondary education, regardless of degree pursuit.

Eligibility phases out at incomes above $80,000 (single) or $160,000 (married filing jointly).

Retirement Savings Contributions Credit

Designed to encourage retirement savings, this credit offsets part of contributions to IRAs, 401(k)s, and similar plans.

Available to taxpayers 18 or older who are not full-time students or dependents, with income limits of $38,250 (single), $57,375 (head of household), and $76,500 (married filing jointly) for 2024.

The maximum credit is $1,000 for individuals and $2,000 for couples.

Tax Credit vs. Tax Deduction

Both tax credits and deductions reduce your tax burden but in different ways.

Tax Credit

A tax credit directly lowers the amount of tax you owe. For example, a $500 credit reduces your tax bill by $500. Refundable credits can result in a refund if they exceed your tax liability.

Nonrefundable credits only reduce tax owed to zero, with no refund for leftover amounts.

Tax Deduction

A deduction reduces the amount of income subject to tax. For example, a $1,000 deduction lowers taxable income by $1,000, saving you money based on your tax bracket (e.g., 22% bracket saves $220).

You can choose the standard deduction ($14,600 for singles in 2024) or itemize deductions if they exceed the standard amount.

Itemized deductions require documentation, while the standard deduction is automatic.

Summary of Tax Credit Types

Tax credits come in nonrefundable, refundable, and partially refundable forms. Refundable credits offer the greatest benefit by allowing taxpayers to receive refunds beyond zero tax liability.

Value of a Tax Credit

The worth of a tax credit depends on its type, your income, and filing status, but all reduce taxes owed dollar for dollar.

Difference Between Tax Credit and Deduction

Tax credits reduce tax owed directly, whereas deductions lower taxable income. For example, a $1,000 credit reduces your tax bill by $1,000, while a $1,000 deduction reduces taxable income by $1,000, saving you money based on your tax bracket.

Final Thoughts

Tax credits are powerful tools that directly reduce your tax liability. Refundable credits can even lead to refunds beyond zero taxes owed, while nonrefundable credits only reduce your tax bill to zero. Tax deductions, by contrast, lower taxable income but don’t directly reduce tax owed. Understanding these differences can help you maximize your tax savings.

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