Many people know that tax credits can help lower the amount of tax money you owe to the IRS.
But what exactly are tax credits? How do they work?
Let’s scroll down to find out!
What is a tax credit?
A tax credit is a dollar-for-dollar reduction in a taxpayer’s final tax bill.
Generally, a tax credit is created to promote or reward certain kinds of conduct that the government deems advantageous to the economy, the environment, or any other essential goal. For instance, you can claim a tax credit if you install solar panels for home use to save energy and protect the environment.
How does a tax credit work?
As previously mentioned, a tax credit lowers the income tax you owe dollar-for-dollar. What does that really mean? Well, take a look at this example:
Suppose that you have to pay $2000 taxes and have a $2000 tax credit—that means your tax will be subtracted to zero, and you will be totally tax-free!
This is also what makes a tax credit different from a tax deduction. A $2000 tax deduction only lowers your taxable income (the amount of income on which you owe taxes), not your final tax bill, by $2,000. So, if you fall into the 22% tax bracket, a $2,000 deduction would save you $440.
What are the different types of tax credits?
There are three types of tax credits: nonrefundable, refundable, and partially refundable. Below are brief explanations of each tax credit category:
1. Refundable tax credits
As the name suggests, you may get a refund from the IRS with refundable tax credits. For instance, if you have $2000 tax due and a $3000 refundable tax credit, you would receive a $1000 refund.
The most popular refundable tax credit is probably the earned income tax credit (EITC). The EITC is a tax credit for low- to moderate-income workers who meet specific requirements regarding family size, filing status, and income.
2. Nonrefundable tax credits
A nonrefundable credit refers to a credit that can only be used to reduce your taxes maximum to $0. It can’t go any lower than that to create a negative tax liability, in which case you’ll get a refund. So, if you’re eligible for a $1000 nonrefundable tax credit, and the tax you owe is only $600—the $400 excess is nonrefundable. Some frequently claimed nonrefundable tax credits are lifetime learning credit (LLC), foreign tax credit (FTC), general business credit (GBC), etc.
3. Partially refundable tax credits
Partially refundable tax credits only reduce a certain amount of your taxes and leave the remaining nonrefundable. The American Opportunity credit, for example, is a partially refundable tax credit that allows you to pay up to 40% of the credit as a tax payment. If you calculate a $1,000 American Opportunity credit, you can claim up to $400 as a refundable tax credit and the rest as a nonrefundable credit.
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