What Is a Tax Credit? How Credits and Deductions Work

BusinessFinanceWhat Is a Tax Credit? How Credits and Deductions Work
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A tax credit can reduce your total tax liability. Read on to learn more about these financial incentives so you can be ready for your next tax preparation period. What Is a Tax Credit? How Credits and Deductions Work

What Is a Tax Credit?

A tax credit is a reduction of tax liability a citizen owes to the government. It is different from a tax refund or rebate. Federal and state governments offer these tax benefits as financial incentives for eligible filers.

Eligibility for tax credits or a specific tax credit amount can depend on an individual’s tax-filing status, federal income tax bracket, IRA contributions, and social security status. It also depends upon engagement in certain economic activities, such as starting a small business or attending secondary education.

How Do Tax Credits Work?

Tax credits you acknowledge at the time of filing will reduce the amount of tax you owe. The IRS allows taxpayers to subtract a standard deduction or a list of itemized deductions from their taxable income to formulate their adjusted gross income. Tax software will perform this task automatically, but it’s best to always review your tax return carefully to confirm you are receiving any and all credits available.

Are Tax Credits Better Than Tax Deductions?

Unlike a tax reduction, a federal tax credit reduces tax liability dollar for dollar. As a result, credits reduce the tax bill or the total tax you owe. In comparison, deductions affect the marginal tax rate or the percentage of taxable income. For example, with a�?property tax deduction, the Internal Revenue Service (IRS) allows taxpayers to deduct a portion of these tax expenses from their yearly federal income taxes.

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3 Types of Tax Credits

These are the three main categories of tax credits you can claim on your federal tax return:

  1. 1.�?Partially refundable: The American Opportunity Tax Credit (AOTC), lifetime learning credit (LLC), and child tax credit are three of the most common partially refundable tax credits. Students use AOTC and LLC to write off education expenses (excluding student loan payments). The child tax credit can be refundable up to $1,400 per qualifying child or individual requiring dependent care.
  2. 2.�?Nonrefundable: Tax deductions of nonrefundable credits can reduce the tax liability to zero during an individual federal tax year but will not pay out a refund. Therefore, a nonrefundable tax credit will not increase a refund amount or surpass the total tax liability.
  3. 3.�?Refundable: Refundable tax credits can potentially create a negative tax liability—e.g., your tax refund would be greater than the amount of tax you paid. An example of a refundable tax credit is the earned income tax credit (EITC), or earned income credit (EIC), a tax credit for low-income, moderate-income, and self-employed individuals.

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