What Is A Tax Credit?

Most of us know that tax credits can save taxpayers money, but how exactly do tax credits work? How do tax credits differ from tax deductions? And how do you maximize tax credits to increase your overall tax refund?

Well, not all tax credits can increase your refund. That’s where refundable and nonrefundable tax credits come in. Don’t worry, we’ll get there. We’ll explain all of the ins and outs of tax credits so you can know exactly what to expect this tax season.

What Is A Tax Credit?

A tax credit is an amount of money taxpayers can claim to decrease the amount owed on taxes. Tax credits affect the total a taxpayer or business owes at the end of their tax calculations by allowing you to reduce the amount of money owed, or even in some cases, increase the amount received in a tax refund.

What Is A Premium Tax Credit?

You may hear the term “premium tax credit” thrown around. This simply refers to a very specific type of tax credit. The premium tax credit is a tax credit that helps low-income taxpayers afford healthcare premiums for themselves and their families.

Is A Tax Credit A Refund?

Tax credits can sometimes result in a tax refund depending on the type of credit and how much you owe in taxes, but not all tax credits are refunds. Some tax credits are nonrefundable or only partially refundable.

Confusing, I know. We’ll dive into the differences between refundable and nonrefundable taxes to help clear things up.

What Is A Refundable Tax Credit?

Tax credits fall into two camps: refundable and nonrefundable. Refundable credits mean that if you qualify for the credit and your tax payment is less than the credit, you get a refund for the difference.

Because tax credits reduce the amount of tax you owe dollar-for-dollar, not every tax credit is refundable, meaning not all tax credits increase your refund. Don’t get us wrong, all eligible tax credits decrease your tax bill, but not all result in extra cash in your pocket.

• Refundable Tax Credits: A tax credit that can be returned to the business owner as a refund if their tax bill is less than the total credit.
• Nonrefundable Tax Credits: A tax credit that cannot be returned to the business owner even if their tax bill is less than the total credit.

Certain tax credits can also be “partially refundable.” Usually, the IRS provides a percentage that can be returned if certain criteria are met for these types of tax credits.

What’s The Difference Between A Tax Credit & Tax Deduction?

While both tax credits and deductions can reduce the amount you owe in taxes, the way these tax allowances work is very different.

Tax deductions reduce your overall taxable income, whereas tax credits reduce the tax bill you owe or increase your tax refund.

For example, say Sarah made $100,000. With the 2023 tax bracket, Sarah would be taxed at 24%. If Sarah qualified for $20,000 of tax deductions, her overall taxable income would be $80,000, so she would be taxed at the 22% mark which would save her quite a bit of her hard-earned money.

If Sarah owed the IRS $5,000 after her deductions were taken out, and qualified for $2,000 of tax credits, then she would only have to pay the IRS $3,000 instead of $5,000.

So while tax deductions and tax credits have fundamentally different applications, they both can be great ways to save money on your taxes. Even better, you can combine the tax deductions and credits you qualify for to get the best of both worlds.

How Do Tax Credits Work?

Tax credits are amounts of money allotted to taxpayers to decrease the amount of money owed to the IRS during a tax year.

The way tax credits work depends significantly on the individual credit. Some tax credits are nonrefundable and simply lower the amount of taxes you owe. Others are refundable and can increase the amount sent on your tax refund check. Others still are partially refundable and include credit caps and percentage reductions.

So while it’s easy to understand how tax credits work on a basic level, understanding whether you qualify for the credit and then calculating the credit is not always as simple.

The IRS is the best source on each tax credit, how it works, and how much you can get per credit, but accountants and certified tax preparers can be great help with this as well.

How To Claim Tax Credits

To claim a tax credit, you’ll need to ensure that you meet all of the eligibility requirements. An accountant or certified tax preparer can help you identify which tax credits you’re eligible for.

Once you’ve determined you’re eligible for a tax credit, you’ll likely have to fill out a specific IRS form to calculate and claim the credit. While the process can seem daunting, the payoff is more than worth it and can save you a pretty penny on your taxes.

FAQs About Tax Credits