Keeping the amount of taxes you owe as low as possible is just good financial sense. When you take advantage of tax deductions and tax credits, you may be able to reduce your tax liability to zero, meaning you don’t owe any federal income tax for the year. In some situations, you might even have tax credits that result in a negative tax liability.
A tax liability is the amount of money you actually owe in taxes after allowing for tax deductions and tax credits. Tax liability is what you owe before deducting prepaid amounts, such as estimated tax payments or taxes withheld from your paychecks. Prepayments are deducted after you calculate your tax liability on your tax return to determine if you still owe money or are entitled to a refund.
A tax deduction works differently than a tax credit. Deductions reduce the amount of your income subject to income taxes. A tax credit is a sum that is subtracted from your tax liability. Suppose your highest tax rate is 25 percent and you take a tax deduction for $1,000. Since you now have $1,000 less taxable income, you save $250. However, if you have a tax credit for $1,000 the entire amount is taken off your tax liability, meaning you save $1,000. The best you can do with tax deductions is to reduce your taxable income enough so that your tax liability is zero. However, some tax credits can result in a negative tax liability.
You have to use IRS Form 1040 or 1040A to claim tax credits. The only exception is the Earned Income Tax Credit, which may also be claimed on Form 1040EZ. After calculating your income, you subtract all of the tax deductions you are entitled to. Next, you calculate the tax you owe. This is your tax liability before you subtract any tax credits. There are two kinds of tax credits: refundable and nonrefundable. If a tax credit is nonrefundable, you only get to subtract the amount of your tax liability or the amount of the tax credit, whichever is less. However, if the tax credit is refundable, you subtract the entire amount of the credit. This can produce a negative tax liability. For example, if your tax liability after deductions works out to $1,500 and you can claim a refundable tax credit for $2,000, you have a negative tax liability of $500. The IRS adds the $500 to any prepaid taxes when figuring your tax refund.
Refundable tax credits include the Earned Income Tax Credit, Additional Child Tax Credit and Health Coverage Tax Credit. The American Opportunity Tax Credit for college expenses is partially refundable, but is due to expire at the end of 2012. Partially refundable means if using the credit results in a negative tax liability, the negative amount is limited to a percentage of the total tax credit. Examples of nonrefundable credits are the Child and Dependent Care Credit, Child Tax Credit and Residential Energy Tax Credit.