Understanding How Tax Credits Work (2024)

Understanding How Tax Credits Work (1)

If you were unhappy with last year’s income tax bill, there are several ways to reduce your overall 2023 tax burden before the April 15, 2024, filing deadline arrives. You can try to qualify for as many tax deductions and exemptions as possible. Or, you can find out if you’re eligible to receive a tax credit.Taxpayers often work witha financial advisor to guide them through claiming different types of credits. Let’s take a look at the credits that you could be eligible for andhow they work.

What Is a Tax Credit?

A tax credit lowers the amount of money you must pay the IRS. Not to be confused with deductions, tax credits reduce your final tax bill dollar for dollar. That means that if you owe Uncle Sam $5,000, a $2,000 credit would shave $2,000off your total tax bill and you would only owe $3,000.

Unlike the value of tax deductions, which reduce your taxable income, the value of tax creditsdoesn’t hinge on marginal tax brackets. So the value of a tax credit for a wealthy person who pays a high marginal tax rate would be the same as the value of someone making a lot less money who pays a lower rate.

Tax deductions lower your taxable income or the amount of your money that’s subject to taxation. You can get a deduction for your IRAcontributions, for example. Instead of paying taxes on a $50,000 salary, you’d be paying taxes on a smaller amount onceyou deduct your IRA contributions.

Tax credits by comparison are a bit harder to come by. They usually take the form of incentivesthat encourage certain actions or serve as benefits for low-to-moderate-income individuals who meet certain requirements.

Types of Tax Credits

Understanding How Tax Credits Work (2)

Generally, tax credits can be refundable or nonrefundable. When you have a refundable tax credit like the Earned Income Tax Credit, you receive part of the credit as a tax refund if it reduces your tax bill to a negative number. In other words, if you receive a $1,000 refundable tax credit but your tax bill is only $500, you’ll get a $500 tax refund.

With a non-refundable tax credit, on the other hand, you won’t end up with a refund if your tax liability falls below zero. So if you have a $2,500 non-refundable credit (like the Adoption Tax Credit) but you only owe $1,000, the extra $1,500 won’t be accessible to you. Some tax credits are partially refundable, meaning that part of the credit can be added to your tax refund.

As an example of a tax credit, let’s break down the Saver’s Credit, which allows taxpayers to claim a percentage of their contributions (either 50%, 20% or 10%) based on their filing status andadjusted gross income. So for the tax year 2023, which has to be filed by April 15, 2024, single tax filers who saved for retirement and had an AGI under $36,500 could qualify for up to a maximum credit of $1,000 ($2,000 if filing jointly).

Other credits benefit electric car owners or parents with childcare expenses. An exhaustive list is available on the IRS website, but the following are some additional federal tax credits you might be eligible to claim:

  • Non-business Energy Property Credit
  • Residential Energy Efficient Property Credit
  • American Opportunity Tax Credit
  • Lifetime Learning Credit
  • Child Tax Credit
  • Premium Tax Credit
  • Health Coverage Tax Credit
  • Foreign Tax Credit
  • Mortgage Interest Credit
  • Low-Income Housing Credit
  • Qualified Fuel Cell Motor Credit
  • Credit for Tax on Undistributed Capital Gain

There are also state-specific tax credits such as California’s Renter’s Credit. You can find out more about these tax breaks by visiting your state government’s website fortax information.

Related Article: What Can You Deduct at Tax Time?

Tax Credit Cuts and Changes

From time to time, the government makes changes to tax credits. Some programs are extended or expire after a certain period. And some have income thresholds that go up or down from one year to the next.

With the Earned Income Tax Credit, the 2023 tax year, the credit is worth up to $7,430 and you can qualify with up to $63,398 in income. To get the credit, your earned income and adjusted gross income can’t be higher than that amount. How you qualify, and how much you qualify for, will depend on your income and how many children you have, as well as your tax filing status.

Congress has the authority to keep or eliminate federal tax credit programs.Two examples include the elimination of the Work Opportunity Tax Credit (WOTC) and the Employer Wage Credit for Activated Military Reservists. The former (WOTC) was a federal tax credit that benefited employers who hired veterans, ex-cons and other groups of people who have traditionally had a difficult time entering certain workplaces. The latter helped small businesses who paid National Guard and Reserve members part of their regular salaries even after they were called to serve.

Keep in mind that expiring or eliminated programs can be extended retroactively, letting taxpayers claim certain credits that have already expired. When changes are made, families and businesses are affected in a variety of ways. In some cases, they can be left at a financial disadvantage when there are major adjustments.

Bottom Line

Understanding How Tax Credits Work (3)

Tax credits help lower Americans’ tax burdens each year. Whether you receive a credit through the purchase of a first home or by making energy-saving adjustments, you can potentially save hundreds or thousands of dollars. By doing some research, you might discover some tax credits that you can use to cut your tax bill for the current tax year or the following one.

Tips for Planning Your Taxes

  • There are plenty of tax credits, and afinancial advisor can help you find them to minimize your tax burden each year.Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If you lost money on an investment, a financial advisor who specializes in tax planning can harvest your losses to offset your tax liability.
  • Tax software can alsomake filing easier. Ourbest tax software roundup will help you pick the right one for your needs.
  • If you want to get ahead of the tax filing deadline,SmartAsset’s free income tax calculatorcan help you figure out how much you will likely pay in income taxes.

Photo credit:©iStock.com/jonas unruh, ©iStock.com/Alphotographic, ©iStock.com/DragonImages

Understanding How Tax Credits Work (2024)


How does a tax credit work for dummies? ›

What Is a Tax Credit? A tax credit lowers the amount of money you must pay the IRS. Not to be confused with deductions, tax credits reduce your final tax bill dollar for dollar. That means that if you owe Uncle Sam $5,000, a $2,000 credit would shave $2,000 off your total tax bill and you would only owe $3,000.

How do tax credits work us? ›

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.

How do tax credits work if you get a refund? ›

Tax credits are amounts you subtract from your bottom-line tax due when you file your tax return. Most tax credits can reduce your tax only until it reaches $0. Refundable credits go beyond that to give you any remaining credit as a refund. That's why it's best to file taxes even if you don't have to.

What is a tax credit in layman terms? ›

A tax credit is a dollar-for-dollar reduction of the income tax owed. A tax credit directly decreases the amount of tax you owe . Common credits include the Earned Income Tax Credit, American Opportunity Tax Credit, and the Child Tax Credit. A credit can be nonrefundable or refundable.

What does a tax credit do to your taxes? ›

A tax credit is a dollar-for-dollar amount taxpayers claim on their tax return to reduce the income tax they owe. Eligible taxpayers can use them to reduce their tax bill and potentially increase their refund.

What are tax credits examples? ›

For example, you can get a tax credit for sending a child to college or purchasing a vehicle that reduces fossil fuel consumption. The tax code includes dozens of credits, each of which has its own eligibility rules. You have to meet those requirements to claim the credit on Form 1040.

Who benefits from tax credits? ›

A number of federal tax credits exist to help taxpayers—primarily those in middle-income and low-income households—reduce the amount of taxes they owe or get the largest refund possible.

Are tax credits worth it? ›

Generally, a tax credit can have a larger impact because it reduces your taxes owed instead of reducing the income you'll get taxed on. Still, it's worth learning about both types of benefits when looking for ways to catch a break on your taxes.

How exactly are tax credits different from rebates? ›

A rebate is an upfront discount that gives you cash back after you make a purchase, and typically more quickly than a tax credit. A point-of-sale rebate gives you that cash back when you make the purchase, effectively reducing the cost of the item purchased. Rebates do not rely on income levels to receive the benefit.

Which tax credits are fully refundable? ›

What Are Some Examples? In U.S. federal policy, the two main refundable tax credits are the Earned Income Tax Credit (EITC) and the Additional Child Tax Credit (ACTC). The EITC is targeted at low-income workers.

What happens if you have more tax credits than you owe? ›

If the credits are greater than the tax you owe, they'll reduce your tax to zero, but you won't receive the balance as a refund. If you qualify for a “refundable” tax credit, you'll receive the entire amount of the credit. If the credit exceeds the tax you owe, you'll receive the remaining amount as a tax refund.

What is the average tax return for a single person making $60,000? ›

If you make $60,000 a year living in the region of California, USA, you will be taxed $13,653. That means that your net pay will be $46,347 per year, or $3,862 per month.

How to get the maximum tax refund? ›

4 ways to increase your tax refund come tax time
  1. Consider your filing status. Believe it or not, your filing status can significantly impact your tax liability. ...
  2. Explore tax credits. Tax credits are a valuable source of tax savings. ...
  3. Make use of tax deductions. ...
  4. Take year-end tax moves.

How to get $10 000 tax refund? ›

  1. Be 18 or older or have a qualifying child.
  2. Have earned income of at least $1.00 and not more than $30,000.
  3. Have a valid Social Security Number or Individual Taxpayer Identification Number (ITIN) for yourself, your spouse, and any qualifying children.
  4. Living in California for more than half of the tax year.
Apr 14, 2023

Do you get a bigger tax refund if you make less money? ›

​​It's your money! Get it!

The Department of Community Services and Development encourages Californians earning under $30,000 a year to file their taxes to claim the California Earned Income Tax Credit (CalEITC), a cash-back tax credit, and receive a larger tax refund.

Do you have to pay back the tax credit? ›

Tax credits can be nonrefundable, refundable or partially refundable. Some of the most popular tax credits are for green purchases, education costs or people with dependents.

Is a tax credit money in your pocket? ›

So, if you owe $1,000 in taxes, a $600 credit will slash your bill to $400. Boom! Tax credits are money in the bank. The more credits you claim, the less money you have to fork over to good old Uncle Sam.

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