Tax credits reduce income tax "dollar for dollar," in contrast with a tax deduction, which reduces taxable income, otherwise known as the amount of income upon which you are being taxed. Tax credits reduce income tax. Tax deductions reduce taxable income. Once you get the idea, you'll never forget it. But it can take a couple repetitions before you see the difference. There are many tax credits available, such as the Earned Income Credit, Education Tax Credits, and Residential Energy Credits. However, before getting into the specifics of how each tax credit works, it is essential to develop an understanding of what tax credits are and why they are so helpful and delicious.
An Example of How Tax Credits Work
Let's say that after figuring in all your deductions, your income tax bill comes to $1,500. But then you discover that you qualify for a tax credit of $500. Your income tax bill is now reduced to $1,000. A $1,500 tax deduction would not have reduced your tax nearly as much as that $500 credit did. A tax deduction would only have reduced the amount of your income being taxed, or "subject to tax." But a tax credit directly reduces tax and is therefore MUCH more powerful. That's the beauty of tax credits: dollar for dollar tax reduction. One dollar of credit reduces one dollar of tax.
Non-Refundable Tax Credits
The great majority of tax credits are "non-refundable," meaning that they can be used to reduce income tax, but will not be paid out to you once your income tax hits zero.
Non-refundable credits include:
- Adoption Credit
- Lifetime Learning Credit
- Retirement Saver's Credit
- Elderly and Disabled Credit
- Residential Energy Credits
Non-refundable credits are excellent. However, taxpayers should not count on receiving the full amount of non-refundable credits if their income tax liability is at or near zero already. For example, the guy at Home Depot may tell you that you are going to get a $1,500 tax credit for buying a certain type of heating and air-conditioning machine. But if your tax liability--what you owe in taxes for the year--is not $1,500 or more, you will not receive the full $1,500. You will only receive enough credit to bring your income tax bill to zero, and no more. This can be frustrating, but that is the way non-refundable tax credits work: they can only reduce your tax, not create a refund.
Refundable Tax Credits
Refundable credits, meanwhile, are exactly what they say they are: refundable. Meaning that even if your tax is already at zero, the credit will still be paid out to you. The Earned Income Credit is the most popular example of a refundable tax credit, but there are others, including:
- Additional Child Tax Credit
- First Time Homebuyer Credit
- American Opportunity Tax Credit
Tax credits can make a big difference at tax time. Anytime you are not getting credit for your credits, you are losing out on money in a dollar-for-dollar fashion and that is not cool. Also keep in mind, though, that because tax credits offer such a "bang for the buck," they often come with many rules and exceptions to the rules attached, so you really have to be careful to make sure you qualify before claiming a tax credit.