Tax Credits Explained - 2023 Updates

Tax credits help reduce what money is owed in taxes by subtracting the credit amount directly from the tax liability due. There are specific eligibility requirements to receive tax credits, and the amount of these tax breaks depends on the type of credit.


Key Takeaways:

  • Tax credits are tax breaks that reduce the tax bill of qualifying taxpayers by a set dollar-for-dollar amount.
  • Tax credits can be refundable, non-refundable, or partially refundable. If a refundable tax credit exceeds the tax liability, the taxpayer can claim the excess credit as a tax refund. Partially-refundable tax credits allow the taxpayer to claim part of the excess credit amount. With non-refundable tax credits, any excess money will be lost.
  • Some common tax credits include the adoption credit, American Opportunity tax credit, child care credit, child and dependent care tax credit, earned income tax credit, life learning tax credit, and retirement saving contribution credit.

Quick Fact

  • The American Rescue Plan Act of 2021 was a $1.9 trillion COVID-19 rescue package that aimed to facilitate the economic recovery of the United States, largely by revising tax credit qualifications.

What Is A Tax Credit?

A tax credit is an example of a tax break that reduces a taxpayer’s tax bill by a set dollar amount. As opposed to different types of tax breaks that reduce an individual’s total taxable income, such as deductions and exemptions, tax credits impact the tax bill directly.

Why Tax Credits Exist

Tax credits are usually offered by state and federal governments in order to encourage certain behaviors that are thought to benefit society in some way. This could be to stimulate the economy, help take care of children, promote post-secondary education, or advocate for environmentally-friendly investments like solar panels or electric vehicles.

Types of Tax Credits: Refundable Vs. Non-Refundable Vs. Partially Refundable

While there are many examples of tax credits that can help reduce someone’s tax bill, they all fall under three distinct categories: refundable, non-refundable, and partially refundable. 

Refundable Tax Credits

The most impactful type of tax break that helps taxpayers save money during the tax season is refundable tax credits. Taxpayers who qualify for a refundable tax credit are subject to receiving the full amount of the tax credit regardless of income or tax liability, even if the credit amount is greater than the total tax balance owed. In this instance, any extra money after the tax liability has been paid will be issued to the taxpayer in the form of a tax refund. 

Two common examples of refundable tax credits include:

  • Earned Income Tax Credit
  • Premium Tax Credit

Non-Refundable Tax Credits

Non-refundable tax credits can reduce what taxpayers owe in tax liability until the tax due to the IRS reaches $0. If the total potential credit amount exceeds what the taxpayer owes in taxes, they will not have to pay any tax liability, but the extra money will not be issued as a refund. This is why these types of tax credits are deemed “non-refundable.” Any money offered by the credit that is more than the tax bill will essentially be “lost” or “wasted” because the taxpayer does not receive the additional refund payment.

There are a few conditions that determine how non-refundable tax credits can reduce a taxpayer’s tax bill when they file their tax return. The first is that non-refundable tax credits are only considered valid during the year of reporting. Secondly, non-refundable tax credits will expire after a tax return is filed. Therefore, non-refundable tax credits cannot be carried over into future years to receive continuous tax benefits. 

Some examples of non-refundable tax credits include:

  • Adoption credit
  • Child Tax Credit (CTC)
  • Child and Dependent Care Credit
  • Lifetime Learning Credit
  • Mortgage Interest Credit
  • Other Dependents Credit
  • Residential Energy Credit
  • Retirement Savings Contributions Credit
  • Work Opportunity Credit

Partially-Refundable Tax Credits

Partially-refundable tax credits fall in between refundable and non-refundable tax credits as taxpayers may be eligible for a small refund amount. The way that partially-refundable credits work is after the tax liability has been reduced to $0 due to the credit, the taxpayer receives a percentage of the leftover credit amount as specified by the specific parameters. 

Some examples of partially-refundable tax credits include:

  • American Opportunity Tax Credit (AOTC)

Tax Credits Vs. Tax Deductions

Tax credits and tax deductions both serve to provide tax breaks for eligible taxpayers but they provide relief in different ways. 

Tax Credits

Tax credits reduce how much a taxpayer owes in tax payments by a direct dollar-for-dollar amount. Unlike tax deductions, tax credits do not impact an individual’s taxable income, instead reducing the tax liability directly.

For example, if a taxpayer calculates that they owe $2000 in taxes but qualifies for a $1500 tax credit, their tax bill will be reduced by $1500 and they will only be required to pay the remaining tax balance of $500.

Tax Deductions

Tax deductions reduce an individual’s tax bill by reducing how much of their income is taxed, also known as their taxable income. The amount by which a tax deduction lowers a person’s taxable income is dependent on their highest federal income tax bracket. Deductions can either be standardized or itemized. Standard deductions reduce the entire amount of income that would be subject to being taxed by a set amount. Itemized deductions are subtracted from a person’s taxable income for each qualifying deduction the taxpayer claims. 

Common Tax Credit Examples

There are many types of tax credits that can help individuals and businesses save money during the tax season. Here are some common examples: 

Adoption Credit

The adoption tax credit is available as a form of tax relief for qualifying taxpayers who adopt a child during the tax year. The maximum amount of the adoption credit will cover up to $14,890 of the adoption costs per child and the credit amount incrementally decreases at certain income levels. Those who reach a modified adjusted gross income (MAGI) of $263,410 or more in 2022 will be completely phased out of this tax credit. The adoption credit is a non-refundable tax credit.

American Opportunity Tax Credit (AOTC)

The American Opportunity Tax Credit is an education tax credit for undergraduate students who purchase qualifying education expenses. Undergraduate students can earn up to $2,500 through the American Opportunity Tax Credit by claiming $2,000 on approved tuition, school fees, books, or supplies, as well as 25% off of the next $2,000, for a total tax credit of $2,500. The AOTC credit is a partially-refundable tax credit that allows taxpayers to claim 40% of the credit’s value as a tax refund, coming out to $1,000 total.

Here are the eligibility requirements for the American Opportunity Tax Credit:

  1. Student Status: Unlike other types of education-based-tax-credits, the American Opportunity Tax Credit is specifically for undergraduate college students. Parents will claim this credit if they pay for the tuition expenses of the student that is their dependent.
  2. Income: Qualifying students who earned a modified adjusted gross income (MAGI) of less than $80,00 for single filers or $160,000 for joint filers are eligible for the full $2,500 tax credit. Taxpayers whose MAGI was between $80,000 and $90,000 for single filers or between $160,000 and $180,000 for joint filers will be eligible for a reduced credit. Single filers who earn more than $90,000 or joint filers who earn more than $180,000 are not eligible for this tax credit.

Child Tax Credit

The child tax credit is one of the most common tax credits that U.S.-based taxpayers can qualify for. This tax credit is available for taxpayers with dependent children who are under the age of 17. When filing their tax return, families must prove to the IRS that their dependent children meet all of the required qualifications for this type of tax credit. 

Here are the eligibility requirements for the child tax credit:

  1. Age: At the end of the year, your child must still be under the age of 17.

  2. Relationship: The minor under the age of 18 must be related to the taxpayer in one of the following ways: son, daughter, foster child, stepchild, sibling, half-sibling, stepsibling, or a descendant of any of those people.

  3. Dependent status: The child must be properly claimed as a dependent for the child tax credit to be eligible. In this case, the child is unable to also file a joint tax return unless they file it with the intention of claiming a tax refund from estimated taxes paid or withheld income taxes. 

  4. Residency: Aside from some exceptions, the dependent child you are claiming on your return must have lived with you for at least 6 months out of the year. 

  5. Financial support: To claim the child tax credit, the filer must have provided at least half of the child’s financial support during the last  tax year. If the child was able to financially support themselves for more than half the year, it is likely that they will not be considered qualified for this tax break. 

  6. Citizenship: For a child to be eligible for the child tax credit, they must be a “U.S. citizen, U.S. national or U.S. resident alien,” and must hold a valid Social Security number, as per the Internal Revenue Service.

  7. Income: Parents or caregivers who claim the child tax credit must also earn an income below certain threshold requirements. The credit will be reduced incrementally as a taxpayer’s income increases above the threshold until eventually, they are not eligible to claim this credit.  

Child and Dependent Care Tax Credit

The child and dependent care tax credit is a tax break specifically for working individuals with dependents who are reliant on their care. This credit is typically for people with children younger than age 13, but the credit may be approved if they have another qualifying dependent. The child and dependent care tax credit ranges from 20% to 30% based on the taxpayer’s income, allowing them to earn up to $3,000 for the care of one dependent or up to $6,000 for two or more dependents. This tax credit is non-refundable.

  1. Dependents: A child who is 12 or younger, a spouse, or another dependent who relies on you for care would be considered an eligible dependent.
  2. Costs: The child and dependent care tax credit requires the taxpayer to have hired a professional, such as a daycare worker, to care for the dependents while they are at work.
  3. Caregiver: The person who was paid to watch the dependent cannot be your spouse or another dependent.
  4. Employment: The taxpayer must hire childcare help to either look for work or go to work to be considered for this tax credit.
  5. Filing Status: The filing statuses that are compatible with the child and dependent care tax credit include single, married filing jointly, head of household, or qualifying widow or widower with a qualifying child.
  6. Tax Return Information: To successfully receive this credit, taxpayers must provide the tax identification number (TIN) of the person hired for childcare help, whether that is their social security number (SSN) or employer identification number (EIN). 

Earned Income Tax Credit (EITC)

The earned income tax credit is helpful in reducing the tax bill for low-to-moderate-income workers in the United States who qualify. The maximum tax savings people can get through the EITC is $6,935 for people with 3 or more children.

  1. Employment: The taxpayer must be employed to be considered eligible for the earned income tax credit.
  2. Income: Taxpayers must make below a certain income threshold to be eligible for the EITC depending on if they are filing singly or jointly. 

Lifetime Learning Credit

The lifetime learning credit is an education-based tax credit that incentivizes taxpayers to invest in continuing their education. Eligible taxpayers can claim 20% of the first $10,000 they spent on qualifying education costs, such as tuition and fees, for a maximum credit of $2000. This is an example of a non-refundable credit, so the taxpayer cannot claim tax refunds if the credit amount exceeds their total tax liability.

Here are the eligibility requirements for the lifetime learning credit:

  1. Student status: Undergraduate, graduate and non-degree or vocational students may be eligible to claim the lifetime learning credit when they file their tax returns.
  2. Income: To qualify for the lifetime learning credit there are certain requirements based on their modified adjusted gross income (MAGI) and whether or not they file jointly. To claim the full tax credit, taxpayers must have a MAGI of less than $59,000, or less than $118,000 if they filed jointly. To receive a reduced credit, the taxpayer may earn between $59,000 and $69,000 if they file singly, or between $118,000 and $138,000 if they file jointly. Taxpayers will not be considered eligible for the lifetime learning credit if their MAGI was more than $69,000 as a single filer or more than $138,000 as a joint filer. 

Retirement Savings Contribution Tax Credit

As an incentive to encourage American workers to put away money for retirement, the retirement savings contribution credit allows low-and-moderate-income workers to be credited on the first $2,000 they invest in retirement accounts. This could be an individual retirement account (IRA), 401k plan, or another type of retirement program. The maximum credit is $1,000 for individual taxpayers and $2,000 for couples, and it is considered non-refundable.

  1. Age: Eligible taxpayers must be at least 18 years old to earn the retirement savings contribution tax credit.
  2. Student Status: Taxpayers cannot be full-time students during the tax year if they wish to earn this tax-credit.
  3. Dependent Status: A Taxpayer cannot claim the retirement savings contribution credit if they are claimed as a dependent on someone else’s tax return.
  4. Income: Taxpayers must earn less than $34,000 for single filers, $51,000 for heads of households, and $68,000 for married couples filing jointly to be considered for this tax credit. 

What Is The American Rescue Plan?

The American Rescue Plan Act of 2021 was instated following the COVID-19 pandemic to reduce the tax burden of qualifying individuals. This plan revised aspects of tax credits, such as the child tax credit and the earned income tax credit, and issued stimulus checks of up to $1,400 for qualifying individuals.

Changes To The Child Tax Credit

  • The child tax credit is now refundable.
  • The credit has now grown from $2,000 to $3,000 per eligible dependent child between the ages of 6 and 17 and to $3,600 for children under 6 years old.
  • There is no longer a minimum income requirement.

Changes To The Earned Income Tax Credit

  • People who would be eligible for the EITC if their children had social security numbers can now claim the version of the credit meant for households without children.
  • The income limit for investments in 2021 was raised to $10,000 or less from $3,650.

Tax credits can lead to extensive savings when it comes to filing your tax return. For advice on maximizing your savings this tax season, get assistance from the experts at Ideal Tax.

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