Understanding How Tax Credits Work (2024)

If you were unhappy with last year’s income tax bill, there are several ways to reduce your overall 2023 tax burden before the April 15, 2024, filing deadline arrives. You can try to qualify for as many tax deductions and exemptions as possible. Or, you can find out if you’re eligible to receive a tax credit.Taxpayers often work witha financial advisor to guide them through claiming different types of credits. Let’s take a look at the credits that you could be eligible for andhow they work.

What Is a Tax Credit?

A tax credit lowers the amount of money you must pay the IRS. Not to be confused with deductions, tax credits reduce your final tax bill dollar for dollar. That means that if you owe Uncle Sam $5,000, a $2,000 credit would shave $2,000off your total tax bill and you would only owe $3,000.

Unlike the value of tax deductions, which reduce your taxable income, the value of tax creditsdoesn’t hinge on marginal tax brackets. So the value of a tax credit for a wealthy person who pays a high marginal tax rate would be the same as the value of someone making a lot less money who pays a lower rate.

Tax deductions lower your taxable income or the amount of your money that’s subject to taxation. You can get a deduction for your IRAcontributions, for example. Instead of paying taxes on a $50,000 salary, you’d be paying taxes on a smaller amount onceyou deduct your IRA contributions.

Tax credits by comparison are a bit harder to come by. They usually take the form of incentivesthat encourage certain actions or serve as benefits for low-to-moderate-income individuals who meet certain requirements.

Types of Tax Credits

Generally, tax credits can be refundable or nonrefundable. When you have a refundable tax credit like the Earned Income Tax Credit, you receive part of the credit as a tax refund if it reduces your tax bill to a negative number. In other words, if you receive a $1,000 refundable tax credit but your tax bill is only $500, you’ll get a $500 tax refund.

With a non-refundable tax credit, on the other hand, you won’t end up with a refund if your tax liability falls below zero. So if you have a $2,500 non-refundable credit (like the Adoption Tax Credit) but you only owe $1,000, the extra $1,500 won’t be accessible to you. Some tax credits are partially refundable, meaning that part of the credit can be added to your tax refund.

As an example of a tax credit, let’s break down the Saver’s Credit, which allows taxpayers to claim a percentage of their contributions (either 50%, 20% or 10%) based on their filing status andadjusted gross income. So for the tax year 2023, which has to be filed by April 15, 2024, single tax filers who saved for retirement and had an AGI under $36,500 could qualify for up to a maximum credit of $1,000 ($2,000 if filing jointly).

Other credits benefit electric car owners or parents with childcare expenses. An exhaustive list is available on the IRS website, but the following are some additional federal tax credits you might be eligible to claim:

There are also state-specific tax credits such as California’s Renter’s Credit. You can find out more about these tax breaks by visiting your state government’s website fortax information.

Tax Credit Cuts and Changes

From time to time, the government makes changes to tax credits. Some programs are extended or expire after a certain period. And some have income thresholds that go up or down from one year to the next.

With the Earned Income Tax Credit, the 2023 tax year, the credit is worth up to $7,430 and you can qualify with up to $63,398 in income. To get the credit, your earned income and adjusted gross income can’t be higher than that amount. How you qualify, and how much you qualify for, will depend on your income and how many children you have, as well as your tax filing status.

Congress has the authority to keep or eliminate federal tax credit programs.Two examples include the elimination of the Work Opportunity Tax Credit (WOTC) and the Employer Wage Credit for Activated Military Reservists. The former (WOTC) was a federal tax credit that benefited employers who hired veterans, ex-cons and other groups of people who have traditionally had a difficult time entering certain workplaces. The latter helped small businesses who paid National Guard and Reserve members part of their regular salaries even after they were called to serve.

Keep in mind that expiring or eliminated programs can be extended retroactively, letting taxpayers claim certain credits that have already expired. When changes are made, families and businesses are affected in a variety of ways. In some cases, they can be left at a financial disadvantage when there are major adjustments.

Bottom Line

Tax credits help lower Americans’ tax burdens each year. Whether you receive a credit through the purchase of a first home or by making energy-saving adjustments, you can potentially save hundreds or thousands of dollars. By doing some research, you might discover some tax credits that you can use to cut your tax bill for the current tax year or the following one.

Tips for Planning Your Taxes

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