What Are Tax Credits?

Definition and Examples of Tax Credits for 2020

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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 a refund or cash back. Others can be carried forward to subsequent tax years and some can even be carried back to previous 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.

Definition and Examples of Tax Credits

Tax credits reduce your tax liability—what you owe the IRS—after you have calculated what you owe. Their effect is the same as if you had made a tax payment. Tax deductions, like the standard deduction, come off your income, reducing it so you calculate your taxes owed on less earnings. Tax credits are the more valuable of these two tax benefits, especially if they are "refundable," which means you are still entitled to them even if you don't owe any tax (more on these below).

The federal government offers 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 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, say your tax liability for the year was $1,500, but you qualified for a $1,000 tax credit. In that case you would owe the IRS only $500. 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 a $500 refund for the difference. 

Types of Tax Credits

There are two types of tax credits: refundable 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.

Available Tax Credits in the 2021 Tax Year

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

The following popular tax credits are in effect as of the 2021 tax year—the return you'll file in 2022.

The Earned Income Tax Credit

The Earned Income Tax Credit (EITC) is refundable credit that's designed to put money back into the pockets of low- and middle-income taxpayers. Strict income limits apply. The maximum credit as of the 2021 tax year is $6,728, the tax return you'll file in 2022, if you have three or more qualifying children.

Childless taxpayers can claim this tax credit, subject to some strict rules, but the American Rescue Plan Act has loosened these rules to a great extent for tax year 2021. The Act also increases the maximum credit for childless individuals from $543 to $1,502.

The Protecting Americans from Tax Hikes (PATH) Act of 2015 requires that the IRS delay tax refunds on returns that claim the Earned Income Tax Credit or the refundable portion of the Child Tax Credit. This gives the IRS extra time to detect fraudulent returns. In most cases, these refunds are released by mid-February.

The Child and Dependent Care Credit

The Child and Dependent Care Credit effectively reimburses you for some of what you must pay to a care provider to watch your children or your disabled dependents while you work or look for work. For the 2021 tax year the credit is temporarily expanded to up to $8,000 in costs for two or more children, or $4,000 if you have only one child or dependent (up from $6,000 and $3,000, respectively, in 2020). Your child must be under age 13 to qualify.

The American Rescue Plan Act also makes some revisions to this credit for tax year 2021. The percentage is increased to 50% for one year only, and the cost limits increase to $8,000 for one child or dependent and to $16,000 for two or more children or dependents.

The Child Tax Credit

Up to $1,400 of the Child Tax Credit has been refundable since tax year 2018, and this will continue to be the case through at least 2025 under the terms of the Tax Cuts and Jobs Act (TCJA).

In the standard code it works out to $2,000 for each of your children who are age 16 or younger as of the last day of the tax year. Earning too much can disqualify you from claiming this credit, but the income limits are pretty high. Your children must meet several qualifying rules as well.

However, the American Rescue Plan increases this credit as well for tax year 2021. It's $3,000 for each child age six to 17, and $3,600 for children under the age of six for one year only. The age limit is increased from 16 to 17 as of the last day of the tax year.

The Credit for Other Dependents

Up to $1,400 of the Child Tax Credit has been refundable since tax year 2018, and this will continue to be the case through at least 2025 under the terms of the Tax Cuts and Jobs Act (TCJA).

In the standard code it works out to $2,000 for each of your children who are age 16 or younger as of the last day of the tax year. Earning too much can disqualify you from claiming this credit, but the income limits are pretty high. Your children must meet several qualifying rules as well.

However, the American Rescue Plan increases this credit as well for tax year 2021. It's $3,000 for each child age six to 17, and $3,600 for children under the age of six for one year only. The age limit is increased from 16 to 17 as of the last day of the tax year.

The Adoption Credit

The Adoption Credit reimburses you for up to $14,440 in adoption expenses per child as of the 2021 tax year. It's not refundable, but you can carry over any unused portion of the credit for up to five additional years, applying it to what you owe the IRS in those subsequent years.

The Credit for the Elderly or Disabled

The Credit for the Elderly or Disabled is available to taxpayers who are age 65 or older or disabled. It ranges from $3,750 to $7,500 as of the 2021 tax year, and income limits apply. You won't qualify if you earn too much.

The Saver's Credit

Technically titled the Retirement Savings Contribution Credit, the Saver's Credit rewards you for contributions you make to an IRA or an employer-sponsored retirement plan. It's worth 10%, 20%, or 50% of your qualifying contributions, with a maximum credit of $1,000 or $2,000 if you're married and file a joint return. The percentage you're entitled to claim depends on your income.

The Premium Tax Credit

The Premium Tax Credit goes hand-in-hand with the Affordable Care Act. It's intended to defray the cost of your health insurance premiums. You must purchase insurance through the Health Insurance Marketplace to qualify, and there are income limits in years other than 2021 and 2022. The American Rescue Plan temporarily eliminates these limits.

The American Opportunity Tax Credit

Also referred to as the "AOTC," the American Opportunity Tax Credit is for qualified education expenses you pay for yourself, your spouse, or your dependents. The maximum credit is $2,500 per student as of the 2021 tax year. It's a percentage of how much you actually spend on educational costs, and income limits apply.

The Lifetime Learning Credit

The Lifetime Learning Credit is another education credit with somewhat more lenient qualifying rules for students. It's worth up to $2,000 per tax return, not per student.

The Recovery Rebate Credit

Many taxpayers received stimulus checks, or Economic Impact Payments, in 2020 and 2021, as a form of government assistance during the COVID-19 pandemic. The first two checks were distributed in 2020, and reported on the taxes filed in 2021. The third check was distributed in 2021, and should be reported for the 2021 tax year, as filed in 2022. Filers who did not receive the final stimulus payment may be eligible for the Recovery Rebate Credit. If you're eligible for a credit and don't owe taxes this year, your credit will provide a tax refund.

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 2021 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.

Key Takeaways


  • 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.