How Tax Credits Work

Reduce Your Tax Bill With Tax Credits

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Tax credits are the best of the best when it comes to tax breaks. Deductions come off your income, reducing it so you pay taxes on less earnings. That's certainly a good thing, but tax credits actually subtract directly from what you owe the IRS. They can effectively erase your tax bill, and some are even "refundable" so you'll get a refund for any credit that's left over after your tax bill is gone.

All this makes credits more advantageous than deductions. But exactly how do these tax treasures work?

What Is a Tax Credit? 

You can claim tax credits for foreign taxes, child care expenses, college tuition and fees, and for costs associated with adoption. You might also be eligible for credits based on your age, your income, or a disability, if you contributed to a retirement savings account, or if you have minor children who live with you and require childcare so you can work.

What Is a Tax Liability?

Your tax liability is what you owe the IRS after you've prepared your Form 1040 tax return. You can find your gross tax liability on line 22 of the new 2018 Form 1040, appropriately captioned "Amount You Owe." 

Your net tax liability—as opposed to your gross tax liability—is the tax you're responsible for paying after you apply for all the tax credits you're entitled to. Most credits are applied to and reduce this amount.

Taxes withheld from your pay during the year are a prepayment against your gross year-end tax liability. Self-employed taxpayers are expected to send in quarterly estimated tax payments, based on what they think they'll earn and owe at year's end.

In either case, you'll receive a refund for anything you pay in that turns out to be in excess of what you actually owe...or if a refundable tax credit eliminates what you owe and there's still some left over. 

Refundable vs. Nonrefundable Credits 

Most credits are effectively wasted after your tax bill is erased because they're nonrefundable. They're still great for eliminating or reducing your tax liability, but they don't go any further than that. For example, if you're entitled to $7,000 in nonrefundable credits and your tax liability is $5,000, you'll owe the IRS nothing because your $5,000 tax debt is erased by the credits, but the IRS will keep the $2,000 balance. 

Contrast this to refundable credits. If you have more refundable credits than you have a tax liability, you'll receive a refund for the balance. The earned income tax credit is an example of a refundable credit. Your tax refund will include any extra income tax that was withheld from your pay, as well as any tax credit excess that didn't go toward erasing your tax debt. Bottom line: You'll get more money back from the IRS than you actually paid in. 

Up to $1,400 of the Child Tax Credit is refundable beginning in tax year 2018 through at least 2025, and up to $1,000 of the American Opportunity educational credit is refundable as well.

A Word of Warning

The Protecting Americans from Tax Hikes (PATH) Act of 2015 requires that the IRS delay refunds on tax returns that claim the Earned Income Tax Credit or the refundable portion of the Child Tax Credit. This allows the IRS a little extra time to avoid fraud, ensuring that everyone who claims these popular credits is actually entitled to do so. In most cases, these refunds are released by mid-February.

Carryover Tax Credits 

A few credits can be carried from one year to the next so you don't lose any of the excesses even if they're not refundable. Sometimes they can even be carried back to previous tax years. The foreign tax credit, the adoption tax credit, and the residential energy credit for certain products all allow carryovers as of 2018.

Available Tax Credits

The following tax credits are available and in effect as of both the 2018 and 2019 tax years.

  • Earned Income Tax Credit (Refundable)
  • Child and Dependent Care Credit
  • Child Tax Credit (Partially refundable)
  • Adoption Credit (Carryover credit)
  • Credit for the Elderly or Disabled
  • Saver's Credit
  • Foreign Tax Credit (Carryover credit)
  • Residential Energy Efficient Property Credit
  • Low-Income Housing Credit (For owners)
  • Premium Tax Credit (Affordable Care Act)
  • American Opportunity Credit (Partially refundable)
  • Lifetime Learning Credit

Some of these, including the Child Tax Credit, phase out at certain upper income limits. As you earn more income, the credit becomes less until it's finally eliminated entirely.

Note: Tax laws and forms change periodically. The above information may not reflect the most recent changes. Please consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and it is not a substitute for tax advice.