Takeaways
- Tax filers qualify for tax credits as part of filing their annual federal income taxes.
- Tax credits lower your tax liability dollar for dollar and vary in their refundability.
- Tax credits fall into three categories: nonrefundable, refundable, or partially refundable.
- Tax filers can use tax filing software or consult a tax professional during tax filing season.
- Popular tax credits include the Child Tax Credit, the Child and Depending Care Credit, and the Electrical Vehicle Tax Credit.
A tax credit is a dollar-for-dollar reduction in your federal income tax liability. This means that for every dollar of tax credit you qualify for, your tax liability is reduced precisely by that amount. Tax credits are more valuable than tax deductions, as they directly reduce your tax liability rather than simply reducing your taxable income.
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How Tax Credits Work
To claim a tax credit, you must meet specific eligibility requirements set by the Internal Revenue Service (IRS). These requirements can vary depending on the tax credit you claim. Once you have determined that you qualify for a tax credit, you must gather the necessary documentation to support your claim.
You typically claim tax credits on your federal income tax return. The specific form you will use will depend on the type of tax credit you are claiming. Once you have filed your return, the IRS will review your claim and determine if you are entitled to the credit. If you are, the credit is applied to your tax liability, and any excess credit will be refunded.
Tax credits benefit individual taxpayers and play a significant role in shaping the economy. They can stimulate economic activity, encourage specific behaviors, and promote social goals by providing financial incentives.
- Stimulating Economic Growth: Tax credits can encourage investment, job creation, and consumer spending. For example, the electric vehicle tax credit incentivizes the purchase of electric vehicles, which can boost demand for these vehicles and support the growth of the electric vehicle industry. With this incentive, you might tilt towards purchasing an electric vehicle if you buy a new car.
- Encouraging Specific Behaviors: Tax credits can be used to promote specific behaviors, such as saving for retirement or investing in education. The Savers Credit and the American Opportunity Credit incentivize these behaviors.
- Promoting Social Goals: Tax credits can address social issues such as poverty, education, and healthcare. The Earned Income Credit, for instance, provides a refundable tax credit to help lift low-income families out of poverty.
As the economy evolves, new tax credits will likely be introduced, and existing ones will be phased out or modified. Some potential areas for future tax credit development include:
- Green energy: Tax credits could incentivize investments in renewable energy sources like solar and wind power. (Read more about ESG Investing).
- Childcare: Tax credits could provide greater support for working families who pay childcare expenses.
- Healthcare: Tax credits could help individuals and families afford healthcare coverage. (Read more about Healthcare Savings Accounts).
- Education: Tax credits could encourage investments in education and training, particularly in-demand skills. (Read more about Student Loans).
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3 Categories of Tax Credits
Not all tax credits work the same. There are three buckets of tax credits: non-refundable, refundable, or partially refundable.
- Refundable: Refundable tax credits are the holy grail of tax credits. These tax credits can reduce your tax liability to zero and qualify you for a tax refund (e.g., the IRS owes you money).
- Nonrefundable: Nonrefundable tax credits reduce your tax liability up to the total credit amount. They can only reduce your tax liability to zero and cannot be rolled to prior tax years.
- Partially Refundable: Partially refundable tax credits operate somewhere between refundable and nonrefundable tax credits. They can lower your tax liability to zero, and depending on the tax credit, they can give you a slight refund by having a portion of the credit phasing into a tax refund.
9 Tax Credits to Know
There are many different tax credits available to taxpayers. Here are nine of the most common tax credits that you should be aware of:
1. Child Tax Credit
The Child Tax Credit is available to taxpayers who have qualifying children under the age of 17.[1] The credit amount is $2,000 per child, with an additional $1,400 available for each child under six.
2. Child and Dependent Care Credit
The Child and Dependent Care Credit is available to working parents who pay for childcare expenses. The credit amount is based on your income and the number of qualifying children or dependents.
3. Adoption Credit
The Adoption Credit is available to taxpayers who adopt a child. The maximum credit amount is $15,950 per child in 2023, with additional funds available for children with special needs. [2]
4. Earned Income Credit
The Earned Income Credit is available to low- and moderate-income working taxpayers. The credit amount is calculated based on your income and the number of qualifying children you have.
5. Savers Credit
The Savers Credit is available to taxpayers who contribute to retirement savings accounts. The credit amount is based on your income and contributions.
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6. Electric Vehicle Tax Credit
The Electric Vehicle Tax Credit is available to taxpayers who purchase a qualifying electric vehicle. The credit amount varies depending on the type of vehicle and the manufacturer.
7. Lifetime Learning Credit
The Lifetime Learning Credit is available to taxpayers who pay for qualified education expenses for themselves or their family members. The credit amount is $2,000 per taxpayer, with a maximum of $10,000 annually.[3]
8. American Opportunity Credit
The American Opportunity Credit is available to taxpayers who pay for qualified education expenses for themselves or their family members. The credit amount is $2,500 per student, with a maximum of $10,000 per year.[4]
9. Premium Tax Credit
The Premium Tax Credit is a refundable tax credit available to taxpayers who purchase health insurance through the Health Insurance Marketplace. [5] The credit amount is based on income and the cost of the insurance.
Other Considerations and Tax Prep
It is important to note that tax credits can be subject to phase-outs based on income. This means the credit amount may be reduced or eliminated if your income exceeds certain thresholds. Some tax credits may also have other eligibility requirements, such as being a U.S. citizen or resident.
If you believe you may qualify for one or more tax credits, it is recommended that you consult a tax professional. A tax professional can help you determine which credits you are eligible for and assist you in claiming them on your tax return. Some of the best tax preparation software can also help you with this process.
Smart Summary
Tax credits are amounts you can subtract from the federal income taxes you owe. Some tax credits lower your tax liability to zero, while others can result in a tax refund. The best online tax filing software will walk you through questions to help you determine your eligibility for different tax credits. If you don’t use online tax filing software, talk to your CPA or tax professional about how to qualify for tax credits.
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(1) Internal Revenue Service. Child Tax Credit. Last Accessed January 13, 2025.
(2) Internal Revenue Service. American Opportunity Tax Credit. Last Accessed January 13, 2025.
(3) Internal Revenue Service. Lifetime Learning Credit. Last Accessed January 13, 2025.
(4) Internal Revenue Service. Adoption Credit. Last Accessed January 13, 2025.
(5) Internal Revenue Service. Premium Tax Credit. Last Accessed January 13, 2025.
