Tax credits are considered to be among the best tax breaks out there. According to the IRS, the tax credit definition is an element that "reduces the amount of tax you must pay.”
That’s a good thing, but the rules for and the amounts of some credits can – and often do – change annually. This can make them hard to get a handle on. Just because you qualify for one doesn’t necessarily mean that you’ll qualify for others. But you’ll hand over less of your money to the IRS in taxes when you do qualify for one or more.
Tax Credit Vs. Tax Deduction
Tax credits aren’t the same as tax deductions. Credits come directly off what you owe the IRS. They’re literally worth a dollar for each dollar you can claim.
Not so with tax deductions. These are only worth a percentage of each dollar you can claim because they come off your taxable income, not your actual tax bill. Basically, the percentage is equal to your marginal tax bracket. If Joe Taxpayer is entitled to a $2,000 deduction and he’s in the 22 percent tax bracket, he’ll save himself $440 in taxes by claiming that deduction. If that $2,000 was a credit, he would shave $2,000 off what you owed the IRS.
The U.S. tax code offers a lot more deductions than credits because, let's face it, the IRS is in business to collect money, not give it away.
Claiming Tax Deductions
Claiming some deductions can actually result in paying more in taxes than you have to, depending on your situation. A handful of deductions are “above the line” – they’re adjustments to income and you can claim them, then also either itemize your other deductions or claim the standard deduction instead. But the majority of deductions can only be claimed if you itemize.
Many taxpayers find that their total itemized deductions amount to less than the standard deduction for their filing status, so they’d be leaving money on the table if they itemized. You can’t itemize and claim the standard deduction, too. You have to choose one or another.
The standard deduction for a single taxpayer is $12,000 in 2018. Joe would be better off itemizing if he had $15,000 in itemized deductions. But if he had only $10,000 in itemized deductions, he would end up paying taxes on $2,000 more in income than he had to if he itemized.
A Tax Credit Example
Now let’s say that Joe Taxpayer is eligible to claim a $2,000 tax credit rather than a $2,000 deduction. Lucky Joe – he saves $2,000 instead of $440. Here’s how it works.
Joe has finished preparing his tax return only to realize that he owes the IRS $2,500. Then he also realizes that he’s eligible to claim the child tax credit for his daughter. That’s $2,000 per child as of 2018. So he goes back to add this to his tax return.
It involves a little more work because he must additionally file Form 8812 when he files his tax return, but it’s worth it because credits are entered after his total tax has been calculated. They act as payments. Claiming a credit is akin to telling the IRS, "I already paid this $2,000," even if you didn't actually do that.
So Joe now owes the IRS only $500 – the difference between his $2,500 tax bill and the $2,000 tax credit he’s eligible to claim.
How Do Tax Credits Affect My Refund?
So what would happen if Joe only owed the IRS $1,500? What would happen to that extra $500 after his tax credit erased his tax bill? That depends on the type of credit he was able to claim.
Most credits are nonrefundable – the IRS will keep that extra $500 after Joe’s tax debt is eliminated. But a few are refundable. The IRS will issue Joe a $500 tax refund for the difference if his credit is one of these.
The same rule applies if Joe didn’t owe any taxes at all. Maybe he contributed enough through payroll withholding or estimated tax payments during the year that those payments cover any tax liability that comes due. In this case, the IRS would send Joe a $2,000 refund – another reason why refundable tax credits are so coveted. And if Joe was already going to receive a $500 refund because he overpaid his taxes during the year, the IRS would send him a check for $2,500 – the amount of the credit plus the refund he was already due.
Partially Refundable Tax Credits
The earned income tax credit is a refundable credit in 2018. The adoption credit and the child and dependent care credit are both nonrefundable. That’s the easy part. Some tax credits are actually partially refundable subject to their own complicated rules. A portion of these credits can only erase your tax bill, but you might get a little cash back as well up to certain limits.
Up to $1,400 of the child tax credit is refundable under some conditions, most having to do with your income. You might be eligible for the American opportunity credit if you spent money on higher education costs during the year. This one allows you to claim $2,500 for each eligible student per year, and 40 percent of anything left over after the American opportunity credit eliminates your tax bill is refundable, up to $1,000.
What Is the Maximum Tax Credits Award?
It’s difficult to pinpoint the biggest, most awesome tax credit because the qualifying rules can differ so much. It can be something like comparing apples to oranges. But the earned income tax credit is often considered to be the best of them all if you qualify. It’s the most commonly claimed credit year after year.
This credit is designed to put money back into the pockets of low-income earners, and the amount of the earned income tax credit depends on a couple of interlocking factors. First, you’re not eligible if you earn too much. Second, the amount of the credit increases with the number of child dependents you have. Joe Taxpayer could earn up to $15,270 in 2018 and be eligible for the earned income tax credit if he has no children, but he could earn up to $49,194 if he has three or more children. The maximum earned income tax credit in 2018 is $6,431 if he has three or more kids. And remember – that’s refundable.
Claiming Credits Appropriately
Some of these credits can be particularly advantageous, so it only makes sense that the IRS keeps a close eye on returns that claim them. Be sure you’re eligible for the ones you claim so you don’t risk an audit. You can read up on the qualifying details of each on the IRS website, but you might want to check with a tax professional to make sure you qualify, or use tax preparation software. Many programs will determine your eligibility for you by asking you a series of questions.
And you might have to wait a little longer for a refund based on claiming the earned income tax credit. The PATH Act of 2015 requires that the IRS must hold back until mid-February before issuing refunds to taxpayers who claim this credit, just to investigate a little and make sure that they really do qualify.
- US Tax Center: Refundable vs. Non-Refundable Tax Credits
- Tax Policy Center: What Is the Difference Between Refundable and Nonrefundable Credits?
- US Tax Center: Tax Credits vs. Tax Deductions
- Tax Policy Center: What Is the Difference Between Tax Deductions and Tax Credits?
- IRS: Five Tax Credits That Can Reduce Your Taxes
- US Tax Center: 2018 Federal Tax Rates, Personal Exemptions & Standard Deductions
- Market Watch: Meet the New, Friendlier Alternative Minimum Tax
- IRS: 2018 EITC Income Limits, Maximum Credit Amounts and Tax Law Updates
- IRS: Refund Timing for Earned Income Tax Credit
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.