Tax credits subtract directly from what you owe the IRS as you complete your tax return. They're even better than tax deductions, because they're applied dollar-for-dollar to your tax debt for the year, and some can even result in cash back. Others can be carried forward to subsequent tax years.
The IRS offers numerous federal tax credits that can help you keep a little more in your own pocket each year, but they each come with their own unique qualifying rules.
What Are Tax Credits?
The federal government offers some tax credits to taxpayers who take a variety of actions that are deemed to be for the public good, such as adopting a child, saving for retirement, or continuing education. Other credits, like the Earned Income Tax Credit (EITC), are designed to bolster the economy, putting spendable dollars back into the pockets of low-income taxpayers.
Tax credits relieve some of the tax burden on individuals, allowing them to keep more of the money they work to earn.
How Do Tax Credits Work?
Tax credits serve the same function as payments to the IRS, working as if you had swiped your debit card or written a check.
For example, you would owe the IRS only $500 if your tax liability for the year were $1,500, but you were to qualify for and claim a $1,000 tax credit. If you were to owe $1,500 in taxes but qualify for and claim a $2,000 refundable tax credit, the IRS would send you the $500 refund for the difference.
Types of Tax Credits
There are two types of tax credits: refundable ones and nonrefundable. Most are nonrefundable.
A nonrefundable tax credit can erase any tax you owe the IRS, bringing your balance down to zero, but the IRS won’t be sending you a payment for any part of the credit that's left over. The IRS gets to keep the balance after your tax liability is erased.
Refundable tax credits work like an overpayment. If your tax burden is less than the amount of a refundable credit, the IRS will send you the remaining payment as part of your tax refund.
Some credits are set up to allow you to roll any unused portion forward to future tax years.
The Earned Income Tax Credit
The Earned Income Tax Credit (EITC) was introduced into the Internal Revenue Code in 1975 with the idea of putting more money into the pockets of low- to moderate-income taxpayers. As the name suggests, you must have earned income from working for an employer or from being self-employed to qualify, but not too much.
The amount of the EITC you qualify for is structured according to how many dependents you have, and your earnings. You won't qualify if you earn too much, but the more dependents you have, the greater your credit will be.
The American Rescue Plan temporarily expanded eligibility for the Earned Income Tax Credit in 2021. The maximum credit available has been increased, and more households are now eligible for the credit, even those whose income didn't qualify in previous years, including:
- More childless house through 25, except full-time students
- Taxpayers over age 65
- Former foster children and homeless youths as young as 18
You'd be entitled to the maximum EITC of $6,660 for the 2020 tax year—the return you’ll file in 2021—if your income is low, and you have three or more dependents.
The EITC income limits for qualifying as a single taxpayer, a qualifying widow(er), or head of household in the 2020 tax year are:
- $15,820 with no qualifying child dependents
- $41,756 with one child
- $47,440 with two children
- $50,594 with three or more children
These thresholds increase for married taxpayers who file joint returns:
- $21,710 with no qualifying child dependents
- $47,646 with one child
- $53,330 with two children
- $56,844 with three or more children
If you don’t have any dependents, you must be at least 25 years old to claim this credit, and you can’t yet have reached age 65 if you don't have any dependents.
If you're married, you must file a joint return with your spouse to qualify. And you won’t qualify even if your earned income comes in under the above limits if you have more than $3,650 in investment or interest income in 2020. You must be a U.S. citizen or a resident alien, and you can’t be claimed as a dependent by any other taxpayer.
The Taxpayer Certainty and Disaster Relief Act of 2020 provides that you can use your 2019 earned income for purposes of calculating your EITC if this will result in a greater credit than using your 2020 income.
The Child Tax Credit
You could be eligible for $2,000 per qualifying child if you have dependent children. They must be younger than age 17 on the last day of the tax year, and both you and your children must have Social Security numbers that were assigned on or before the tax due date for the year. This rule went into effect in 2018.
The Child Tax Credit (CTC) is partially refundable—you can get up to $1,400 back after it reduces your tax bill to zero.
Each child must be your biological offspring, your adopted child, a foster child placed with you by a government agency, or your stepchild. If the child happens to have any income of their own, they can't have provided half or more their own financial support during the tax year. You must claim the child as your dependent, and the child must be a U.S. citizen and must have lived with you for at least half the year, although temporary absences are allowed.
As with the EITC, you can’t earn too much if you hope to qualify for the full $2,000 credit per child, but the income limits are generous: $200,000 for single filers and $400,000 for married couples who file jointly. You must subtract $50 from your tax credit for every $1,000 you earn over these limits.
The American Rescue Plan also expanded the CTC, making it fully refundable and available to more households. Single filers with incomes up to $75,000, and couples making up to $150,000 now receive the full amount. The benefit amount also increased, to $3,000 for children ages 6 through 17, and $3,600 for children ages 5 and under.
The Credit for Other Dependents
The Tax Cuts and Jobs Act provides for a $500 non-refundable family tax credit if your child is age 17 or older—too old to qualify for the child tax credit. The IRS refers to this credit as the "Credit for Other Dependents," and you can claim it for qualifying adult dependents as well. Unfortunately, this one isn’t refundable. The same income limits apply.
Under the American Rescue Plan, children who are age 17 can now temporarily qualify for the Child Tax Credit.
The Senior Tax Credit
You might be able to claim the tax credit for the elderly and disabled, sometimes called the “Senior Tax Credit,” if you’re at least age 65 or you're disabled. Again, if you earn too much, you won’t qualify, and the thresholds are low:
- $12,500 in adjusted gross income if you're married, filing a separate return, and lived apart from your spouse throughout the entire year
- $17,500 if you’re a single filer
- $20,000 if you're married and filing a joint return, and one spouse qualifies
- $25,000 if you're married, filing a joint return, and both spouses qualify
More complicated calculations come into play if you have non-taxable Social Security or other retirement income. The amount of this credit ranges from $3,750 up to $7,500 for tax year 2020.
The Child and Dependent Care Credit
You might qualify for the Child and Dependent Care Tax Credit (CDCTC) if you pay a caregiver to watch over your child or children who are under age 13 so you can work or look for work. You can also qualify if you have a disabled adult dependent who needs care, or if your spouse is incapable of self-care so you must pay someone to take care of them.
This credit can be as much as 35% of the qualifying expenses up to $3,000 for one child or dependent, or $6,000 for two or more qualifying dependents, but it's also subject to income limits that affect the percentage you can claim.
The American Rescue Plan temporarily expanded the CDCTC as well. In 2021, it covers 50% of the costs of care, up to $4,000 for one dependent or $8,000 for more than one dependent. Income thresholds were also raised, so taxpayers making up to $125,000 are eligible for the full amount, with the credit phasing out to 20% for those making up to $400,000. The CDCTC was also made fully refundable.
Married taxpayers who file separate returns generally aren’t eligible for this tax credit, but you might be exempt from this rule if you meet certain requirements.
Educational Tax Credits
Two educational tax credits are available in the 2020 tax year: the Lifetime Learning Credit and the American Opportunity Tax Credit. Each allows you to deduct a percentage of what you pay in tuition and related qualifying costs for yourself, your spouse, or your dependent to pursue post-secondary education.
The American Opportunity Credit is worth up to $2,500, and it’s partially refundable up to 40% of the amount of the credit you qualify for. Income limits of $180,000 apply for married taxpayers filing jointly, or $90,000 for all others.
The nonrefundable Lifetime Learning Credit is worth up to $2,000. Income limits for this credit are $138,000 for married taxpayers filing joint returns, and $69,000 for all others.
Rules determine the nature of educational expenses that qualify. You can claim one of these credits but not both.
Tax Credits vs. Tax Deductions
Unlike tax credits, deductions are subtracted from your gross income. If you earned $50,000 last year and can claim $10,000 in deductions, the IRS will only tax you on $40,000, for example.
That’s certainly a good thing, but it's not quite as nice as a dollar-for-dollar reduction of your tax bill.
|Tax Credits||Tax Deductions|
|Reduce the amount you owe the IRS||Reduce your taxable income|
|Do not affect your adjusted gross income (AGI) and eligibility for other credits||Can reduce your adjusted gross income (AGI) to qualify you for other tax breaks|
|Can result in a tax refund for any part of the credit that's left over after reducing your tax to zero||Aren't refundable|
Income Requirements for Tax Credits
Most of the earnings limits mentioned here refer to your adjusted gross income (AGI), not the overall amount of money you earned for the year. Your AGI is what’s left after you take certain allowable adjustments to your taxable income to reduce it, but before you subtract your standard deduction or itemized deductions.
You can find your AGI on Line 11 of your 2020 Form 1040.
Some credits use your modified adjusted gross income (MAGI) instead, although this is the same as your AGI for most taxpayers. Some rarely taken deductions are added back in to arrive at your MAGI.
Check with a tax professional if you’re unsure what your MAGI is.
Be very sure that you’re eligible to claim these tax credits or others before you actually do so, because the rules can be intricate and complicated. You might think you qualify when you don't, so check with a tax professional if you have any doubts.
You don’t want to risk an IRS audit. At the very least, the IRS will reach out to you for corroborating documentation to prove that you qualify.
- Tax credits are dollar-for-dollar reductions of your tax bill.
- Credits can be better than tax deductions, because deductions only reduce your taxable income.
- Most tax credits are nonrefundable, but claiming some can result in the IRS sending you cash for anything that's left over after erasing your tax bill.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to them. For current tax or legal advice, please consult with an accountant or an attorney.