What Are Tax Credits?

How Tax Credits Work

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 of 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.

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.

Tax Credit Example

Tax credits serve the same function as payments to the IRS. Its just as if you had swiped your debit card or written a check to the IRS.

For example, suppose 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.

You can also 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 that you can go to work.

The following popular tax credits are in effect as of the 2022 tax year—the return filed in 2023.

The Earned Income Tax Credit

The Earned Income Tax Credit (EITC) is a 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 2022 tax year is $6,935.

Childless taxpayers can claim this tax credit, subject to some strict rules. The maximum credit for childless individuals for tax year 2022 is $560.

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 2022 tax year, the credit will cover a percentage of your work-related expenses of up to $6,000 for two or more children or dependents ($3,000 for one). Your child must be under age 13 to qualify.

The Child Tax Credit

Up to $1,500 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.

The Adoption Credit

The Adoption Credit reimburses you for up to $14,890 in adoption expenses per child as of the 2022 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 amount of the credit is 100% of the first $2,000 of qualified education expenses you paid for each eligible student and 25% of the next $2,000 of qualified education expenses you paid for that student. The maximum credit is $2,500 per student as of the 2021 tax year. It's good for the first four years of higher education and granted as 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 flexible in terms of qualifying rules for students, but some limits still apply. This credit can help pay for undergraduate, graduate, and professional degree courses, including courses to acquire or improve job skills. It's worth up to $2,000 per tax return, not per student, and it's not limited to just the first four years of higher education.

Tax Credits vs. Tax Deductions

Unlike tax credits, deductions are subtracted from your gross income. For example, if you earned $50,000 last year and can claim $10,000 in deductions, the IRS will only tax you on $40,000.

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 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. 

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.

Frequently Asked Questions (FAQs)