Filing your taxes can be intimidating, but you might be able to lower your tax bill with tax credits. Tax credits are the golden ticket of the tax world since they reduce what you owe dollar for dollar and sometimes even lead to an unexpected refund.
If you qualify, you could keep more cash in your bank account and send less to Uncle Sam. Read on to learn how tax credits work and how you can use them to reduce your tax bill.
What are tax credits?
Tax credits reduce the amount of taxes you owe to your state or the federal government. They reduce your tax bill directly, dollar for dollar. If you owe $1,000 in taxes and qualify for a $600 tax credit, your final tax bill will only be $400.
Both the federal government and state governments offer tax credits for a variety of reasons, often to incentivize certain behaviors. For instance, people who install solar panels on their homes may qualify for the federal residential solar energy credit of up to 30%.¹
While the tax credit definition is simple, the eligibility requirements can be more complex. Tax credits are available for many reasons, including child care, child adoption, education, retirement savings, and mortgage interest.
The amount you qualify for can also vary depending on your income, filing status, and other factors. A tax advisor or tax preparation software can help you find tax credits that apply to your situation if you want to file your taxes online.
Types of tax credits
Tax credits reduce the amount you owe in taxes. If you claim a credit when you file your taxes, you’ll see your bill go down (or refund go up). If you claim a credit after filing, you may receive a refund if you’ve paid more taxes than you owe.
There are three main types of tax credits:
These are the best types of tax credits because you’ll receive the full amount even if your tax bill goes down to zero. Let’s say you owe $400 in taxes and qualify for a $600 tax credit. Not only will your tax bill go down to nothing, but you’ll also receive a refund of $200.
Nonrefundable tax credits can reduce your tax bill to zero. However, they won’t generate a refund after your tax bill reaches $0. Using the above example, you’d see your $400 tax bill go down to zero, but you wouldn’t get the $200 remainder with a nonrefundable tax credit.
Some tax credits are a hybrid of refundable and nonrefundable, offering you a partial amount if the tax credit exceeds your tax bill. The American Opportunity Tax Credit for college students is one example. If your tax liability goes down to $0 after using the credit, you could receive a refundable credit of $1,000 or 40% of the remaining credit, whichever is less.
Common tax credits
While there are a variety of tax credits offered at the federal and state levels, here are some of the most common (and most significant) you might qualify for.
Child Tax Credit
The Child Tax Credit helps ease the costs of raising kids. In the 2021 tax year, this credit was worth up to $3,600 for kids under six and $3,000 for kids between six and 17. The amount you could claim started to phase out at incomes of $75,000 or more ($150,000 for married couples and $112,500 for heads of household). Our guide to the Child Tax Credit explains more.
Earned Income Tax Credit
The Earned Income Tax Credit is worth up to $6,935 for the 2022 filing year. It’s available to people who are 19 or older (or students who are 24 or older) and aren’t claimed as a dependent on anyone else’s tax return.
You will receive an amount based on income, household size, and other factors. You can’t qualify if you received more than $10,300 from investment income.
Generally, the Earned Income Tax Credit is worth investigating if your adjusted gross income is less than $53,057 as a single filer and less than $59,187 as a married couple (though amounts and guidelines change every year). Many individual states also offer their own version of the Earned Income Tax Credit.
American Opportunity Tax Credit
The American Opportunity Tax Credit helps families who are paying for higher education. It offers up to $2,500 for qualifying higher education expenses, including tuition and course materials.
It covers all four years of college as long as the student is enrolled at least half-time. You could qualify for the full credit if your modified adjusted gross income is $80,000 or less as a single filer or $160,000 or less as a married couple filing jointly.
As mentioned, the American Opportunity Tax Credit may offer a partial refund if your tax bill goes down to $0 and you still qualify for an additional amount.
Tax credits in your state
Many states that collect income taxes offer tax credits to residents.
California, for example, offers a tax credit of $60 for individuals and $120 for married filers who paid rent in California for at least half the year and meet income and other guidelines.³ Massachusetts offers a tax credit of $1,500 if you remove lead paint from your home.4
As mentioned, many states also provide qualifying taxpayers with an earned income tax credit. If you qualify for a state tax credit, it could reduce the amount of taxes you owe to your state.
Tax credits vs. deductions
Let’s say, for example, your taxable income is $40,000. The tax bracket for single filers making $40,000 is 12%.
Find out what tax bracket you’re in.
Without any tax credits or deductions, you’ll owe $4,800 in taxes.
Now let’s say you qualify for a $4,800 tax credit. You’ll save $4,800 on your tax bill, meaning you won’t owe anything.
But if you qualify for a $4,800 tax deduction, your savings will only be $576. The deduction will reduce your taxable income from $40,000 to $35,200, and you’ll owe $4,224 in total.
Though both are beneficial, tax credits are more valuable than tax deductions.
Is a tax credit a refund?
A tax credit reduces your tax bill, dollar for dollar. Depending on the type of tax credit, you could receive a refund if the credit exceeds your tax liability.
Is a tax credit a good thing?
A tax credit is generally a good thing, since it lowers the amount you owe in state or federal taxes. You might even get money back, depending on the type of credit and how much you owe.
What are the three types of tax credits?
The three types of tax credits are refundable, nonrefundable, and partially refundable. Refundable tax credits are the most valuable, since they refund you the difference if the credit exceeds your tax bill. Nonrefundable tax credits can reduce your tax bill to $0, but they don’t offer a refund after that. Partially refundable credits can offer a refund after your tax liability goes down to zero. Still, the amount will vary and won’t add up to the maximum amount of the credit.
How much is a tax credit worth?
The amount a tax credit is worth varies depending on the credit itself, your income, and other factors. Refundable tax credits are worth the most since you’ll receive the full amount of the credit regardless of how much you owe in taxes.
Find out what tax credits you qualify for this tax season
Tax credits can help you keep more of your hard-earned cash in your pocket when it’s time to file your taxes. Most tax credits are reserved for low- and middle-income taxpayers, though you might also qualify for special circumstances like adopting a child or purchasing an electric vehicle.
While filing taxes can be a process, it’s worth exploring your options for tax breaks. By arming yourself with this knowledge, you may discover opportunities to save.
If you’ve been spending money on education expenses, discover commonly-overlooked education tax credits and deductions to maximize your refund.