A tax credit allows you to deduct a certain amount of money from the taxes you owe. It differs from a tax deduction, which allows you to reduce your taxable income. Tax credits are available to taxpayers for several reasons.
Some popular tax credits you may qualify for
American opportunity tax credit
Child tax credit
Income tax credit
Premium tax credit
Travel tax credit
Two of the main reasons the government grants tax credits are encouraging certain behaviors or reducing the tax burden on economically disadvantaged taxpayers. Tax deductions are often motivated in the same way and have less financial value in most cases. This is because the value of a tax credit is dollar for dollar, while a tax deduction reduces gross income, which will always be taxed at a person's marginal rate.
What is a tax credit?
A tax credit is a sum of money that a taxpayer can deduct from taxes owed. There are three types of tax credits:
A non-refundable tax credit
A partially refundable tax credit
A refundable tax credit
Refundable tax credits are probably the most beneficial type of tax credit for taxpayers because they are paid in full. This means, for example, that if the amount of the refundable tax credit is greater than the tax due, the additional dollar amount above zero results in a cash refund.
Non-refundable tax credits are only valid in the current fiscal year, which means that they cannot be carried forward to subsequent years. Therefore, although a taxpayer can continue to deduct non-refundable tax credit amounts from taxes owed until the tax burden is zero, the remaining non-refundable tax credits do not result in a cash refund.
Partially refundable tax credits are a mixture of non-refundable and refundable tax credits. These tax credits are refundable, so the taxpayer will be refunded if the credit amount exceeds the tax owed but will not receive the full amount. Instead, they will receive a percentage of the remaining credit or a fixed amount, regardless of the remaining amount of the tax credit.
Example of tax credit
To clarify the distinction, let's take a look at someone whose taxable income of $60,000 is generated through self-employment or business. An itemized deduction, such as a business expense, would be included in the income tax return, particularly the Form 1040 Schedule C.
In this example, spending $10,000 on a business would reduce the adjusted gross income (AGI) to $50,000. The self-employed tax rate is 15.3%, which means a tax burden of $9,180. However, this taxpayer may find additional tax benefits through a tax credit program.
As mentioned earlier, a state or federal tax credit does not reduce adjusted gross income but rather decreases individual taxable income dollar for dollar. A child credit, for example, could reduce someone's taxes by $3,000, bringing taxes owed to $6,180.
Some popular tax credits you may be eligible for
American opportunity tax credit
This tax credit is intended for students or parents of students who wish to obtain a degree. It allows up to $2,500 for each eligible student, with a maximum of 40% (up to $1,000) of the remaining amount refunded if the tax burden is greater than zero.
Technically, the American opportunity tax credit covers 100 percent of all expenses up to $2,000 and 25 percent of expenses beyond those of the first four years of higher education (usually with a bachelor's degree).
To apply for this credit, the educational institution must issue Student Form 1098-T. The taxpayer's deposit should also not earn more than $80,000 as a single taxpayer or $160,000 for a couple filing together. A reduced credit may be required for single taxpayers who earn between $80,000 and $90,000 and couples who file jointly and earn between $160,000 and $180,000. Taxpayers whose adjusted gross income exceeds these dollar amounts may not be able to claim the American opportunity tax credit.
Child tax credit
The child tax credit is intended to cover childcare costs. For fiscal 2021, taxpayers can deduct expenses of up to $3,000 for each dependent under age 18 and $3,600 for dependents under age 6.
The child tax credit was partially refundable, and taxpayers could claim up to $1,400 per child for any excess amount. This tax credit was intended to help families whose tax burden was lower than the number of credits they could claim.
The American Rescue Plan Act 2021 made some changes to this tax credit, including fully refundable and payable in advance. Therefore, in 2022, unless this temporary legislation is extended, the child tax credit will return to its previous rules of $2k per child under 17 for a partially refundable credit with the refundable part (called the additional child tax credit) limited to $1,400 per eligible child.
There is a similar type of tax credit called dependent care. This tax credit is intended to finance the care of dependents - someone who lives with you and to whom you provide at least 50% financial assistance.
Children and adults can receive dependent care. Adults can include parents, relatives, or even someone who has lived with you all year round, as long as your income is less than $4,300 per year and you have not been declared a dependent by another.
You cannot claim a spouse as a dependent. However, a federal tax credit for a dependent child can include biological children, stepchildren, adopted children, and even siblings provided they are under 19 or under 24 and attended school for at least five months a year.
Earned Income Tax Credit
The Earned Income Tax Credit is a fully refundable tax credit for low- and moderate-income workers, employees, or the self-employed, provided they are between the ages of 25 and 64 and have lived in the United States for at least half a year. The tax credit amount depends on several factors, such as income and the number of dependents.
For example, in 2021, a single taxpayer with no dependent earning less than $15,980 could claim a tax credit of $543, while a couple with three employees earning no more than $57,414 could claim $6,728. Although the earned income tax credit is available to anyone earning income and having investment income of less than $10,000 (as of 2021), it is only one of the many tax exemptions available for self-employed workers. These taxpayers can reduce their tax burden by writing off their business expenses and deducting them from their gross income as a deduction from the Home Office.
Premium tax credit
The premium tax credit is intended to finance health insurance for taxpaying couples and people who earn a lot of money to benefit from free health care but who do not have an occupational disease insurance scheme.
These taxpayers must have obtained their insurance through a health insurance market. In many cases, they may be eligible for an advance payment made directly to the health insurance provider to reduce the monthly payment for continued coverage.
Travel tax credit
The American Tax Rebate and Incentive Program (TRIP) introduced by Arizona Senator Martha McSally would provide a tax credit to Americans traveling at least 50 miles from home in the United States and/or its territories in the years 2020 and 2021.
As you can imagine, this tax credit is intended to stimulate the activity of the tourism industry, which has been particularly affected by the COVID pandemic. This tax credit would provide up to $4,000 for single taxpayers and $8,000 for joint taxpayers for all travel expenses, with a few exceptions - those who stay in their own vacation home will not be able to write off their mortgage and taxes as part of the travel credit.
The Cares Act
The Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed to mitigate the financial impact of COVID-19 on Americans. In addition to the incentive allowance payments, there are additional tax reduction measures under the CARES Act.
For entrepreneurs, the employee retention credit is a refundable tax credit for employees with a credit of up to 50% of the eligible salary paid to employees from March 12, 2020, until the rest of the year. As you can imagine, the purpose of this tax cut was to motivate entrepreneurs to keep their employees and keep the business afloat, which in turn puts less of a burden on public labor services.
Other elements of the CARES Act include the non-taxable nature of emergency incentive payments. The American Rescue Plan, signed into law in 2021, extends some of the benefits of CARES. The child tax credit has increased from $2,000 to $3,000 for children under 17 and from $3,600 for children under six. In addition, the entire tax credit is now refundable, whereas previously, the refund was limited to $1,400.
This bill also increased the labor income tax credit and the removal of the age barrier for those over 65s and the lowering of the minimum age barrier from 25 to 19 in terms of eligibility.
Conclusion
As you can see, tax credits are designed to encourage certain behaviors (like going to college, doing paid work, or traveling) or providing financial assistance to people with low and modest incomes), which offers an additional refund.
There is a great deal of information on the Internet on all tax credits, much of which is available on the IRS website. However, it is generally beneficial to work with a tax advisor who is knowledgeable about tax law and has experience in helping people prepare their taxes most cost-effectively.
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