A tax credit is a dollar-for-dollar reduction in the amount of taxes a taxpayer owes to the IRS. Unlike a tax deduction, which reduces taxable income, a tax credit directly lowers the amount of tax due. Tax credits are highly valuable because they can either reduce or eliminate a taxpayer’s liability, and in some cases, result in a refund.
Tax credits come in two forms:
- Refundable tax credits: These credits not only reduce tax liability but can also result in a refund if the credit exceeds the amount of taxes owed. Common refundable credits include the Earned Income Credit (EIC) and the Additional Child Tax Credit.
- Nonrefundable tax credits: These credits reduce tax liability to zero but cannot result in a refund if the credit exceeds the tax owed. Examples include the Lifetime Learning Credit and the Saver’s Credit.
Tax credits are designed to incentivize certain behaviors, such as education, retirement savings, and energy-efficient home improvements. Taxpayers should carefully review available credits each year to ensure they maximize their tax savings and take advantage of all applicable benefits.