A tax credit is a sum of money that taxpayers can subtract from the amount of tax they owe. They differ from deductions in that they do not reduce the amount of taxable income, but instead reduce the amount of tax they are liable to pay.
There are many different types of tax credit and the value of each differs depending on the type of credit. Tax credits can be granted to individuals or businesses in certain locations, classifications or industries.
How tax credits work
Tax credits can be granted by governments for a variety of reasons. It may be to incentivise certain behaviors such as replacing older appliances or machinery with more energy-efficient ones or it could be to benefit disadvantaged taxpayers by reducing the total cost of housing.
One of the biggest differences between tax credits and deductions is the amount by which it reduces the tax bill. For example, an individual in the 22% tax bracket would reduce their tax by $0.22 for every dollar in their deductions. But they would save the whole dollar with a tax credit.
Types of tax credits
The three main types of tax credits are nonrefundable, refundable and partially refundable.
Nonrefundable tax credits
Nonrefundable tax credits are directly subtracted from the tax liability until the tax due is $0. If there is an amount greater than the tax owed, it is not paid back to the taxpayer. Which is where the name nonrefundable comes from. Any remaining amount of a nonrefundable tax credit is effectively lost.
They are valid only for the year of reporting and cannot be carried over to future years. Typically, low-income taxpayers are often unable to use their entire amount of tax credit. Types of nonrefundable tax credits include credits for adoption, the Lifetime Learning Credit, the Child and Dependent Care Credit, the Saver’s Tax Credit and the Mortgage Interest Credit.
Refundable tax credits
The opposite of nonrefundable tax credits is refundable tax credits. As the name suggests, this type of tax credit does pay a refund to the taxpayer if they do not claim all of their tax credit. Meaning that taxpayers are entitled to their full amount of tax credit.
An example of a refundable tax credit is the Earned Income Tax Credit for low to moderate-income taxpayers who earned an income either through an employer or working as a self-employed individual with a business or a farm. They must also meet set criteria based on income and family members. Other examples of refundable tax credits include the Premium Tax Credit which helps to cover the cost of health insurance premiums.
Partially refundable tax credits
These types of tax credits do offer refunds to taxpayers that have not claimed their full credit amount but only at set allowances. For example, since 2018 The Child Tax Credit has paid refunds up to $1,400 per qualifying child.
Another example of a partially refundable tax credit is the American Opportunity Tax Credit. Designed for post-secondary education students, if the full tax credit of $2,500 isn’t used then the taxpayer can claim the lesser of either 40% of the remaining credit or $1,000.
For example, if a student has used $2,000 of their tax credit to reduce their tax liability they would be eligible to claim 40% or $200 of the remaining $500 tax credits. But if they had used $0 of their tax credit they could claim $1000 back as a refund.