What Is a Federal Tax Credit?
In its simplest terms, a tax credit is the amount of money a taxpayer can directly subtract from the taxes they owe. Tax credits reduce the taxpayer’s liability dollar for dollar. Similarly to a tax deduction, a tax credit can reduce the amount of tax you are required to pay at the end of the year, while also increasing your tax refund in certain circumstances. However, this depends entirely on the type of tax credit.
Types of Tax Credits
There are different types of tax credits for qualifying tax filers. All tax credits will fall under one category; refundable, non-refundable, and partially refundable tax credits.
Non-Refundable Tax Credits
Non-refundable tax credits are deducted from a taxpayer’s tax liability until the amount of tax due equals $0. Any amount greater paid that exceeds the tax that is owed is not refunded, hence the term “non-refundable” tax credit. Because of this, these types of tax credits may not always be beneficial, especially to low income taxpayers.
Refundable Tax Credit
These types of tax credits are refundable to taxpayers. If an individual’s tax credit reduces their tax liability to below zero, then that taxpayer will be issued a refund in that amount. Examples of refundable tax credits include the Earned Income Tax Credit (EITC) and the Additional Child Tax Credit.
Partially Refundable Tax Credit
Partially refundable tax credits are exactly as the name suggests and apply to specific tax credits such as the American Opportunity Tax Credit for students seeking post-secondary education. These credits partially refund taxpayers, with the amount of the refund depending on the type of non-refundable tax credit it is.
Finally, tax credits are available both federally and at the state level. Tax credits are used as a way to incentivize Americans to make purchasing decisions that benefit the greater economy, government, or any other high-priority interests the government deems important.
Some of the more common tax credits available for Americans include the Child Tax Credit, the Electric Vehicle and Fuel Cell Electric Vehicle Tax Credit, and the Lifetime Learning Credit.
Tax Credit vs Tax Deduction: What’s the Difference?
Tax credits can sometimes be confused with tax deductions, but the two operate separately and offer their own unique benefits. Unlike a tax credit, a tax deduction is a dollar amount that a taxpayer can reduce their taxable income by. Unlike a tax credit, a tax deduction is not dollar for dollar, but a percentage based on the individual’s tax bracket. For example, if an individual is at a 22% tax bracket, they would save $0.22 for every tax dollar deducted.
Do You Qualify for Tax Credits?
Understanding how federal and state tax credit work can be overwhelming. Working with a certified public accountant is the best way to determine what tax credits and tax deductions you qualify for. Staying up to date, having a general sense of what tax bracket you fall in, what deductions and credits you may be eligible for, and how these tax credits can impact you is the best way to ensure you are paying the taxes you owe and are getting back the refund you deserve.
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