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Tax credit

Have you heard of tax credits but are unsure how they work? Bankrate explains.

What is a tax credit?

A tax credit is an incentive that lets a taxpayer subtract a set amount from their local, state, or federal tax liability. Governments offer tax credits in an effort to incentivize certain desired behaviors or support public goods, such as buying a first home, paying for child care, or caring for an elderly parent.

Deeper definition

Tax credits are distinct from tax exemptions or tax deductions. A tax credit reduces the total amount of tax owed. Separately, a tax deduction is a portion of taxable income that may be excluded from taxation when certain conditions are satisfied, while a tax exemption constitutes income that is not subject to taxation in the first place.

There are three broad categories of tax credits:

  • Refundable credits: Refunds are granted to eligible taxpayers if the value of the credit exceeds total tax liability. The earned income tax credit is the most common refundable tax credit, with rebates of up to 100 percent of the value of the credit that exceeds tax liability.
  • Nonrefundable credits: These credits only count against tax liability and offer no possibility of tax refunds.
  • Partially refundable credits: Currently, there is only one such federal tax credit, the American Opportunity Tax Credit (AOTC). It has a maximum value of $2,500 and aims to reduce the cost of postsecondary education. If a taxpayer reduces her tax liability to zero before using the entire portion of the credit, 40% of remaining eligible credit may be refundable.

The U.S. federal government usually grants a tax credit for special circumstances and certain groups:

  • Elderly and disabled taxpayers usually receive nonrefundable tax credits.
  • Contributors to a retirement savings account receive nonrefundable tax credits.
  • Various mortgage programs grant nonrefundable tax credits.
  • Under the Affordable Care Act (ACA), individuals who obtain health insurance via an exchange receive refundable tax credits if their income falls below certain thresholds.
  • Low-income parents receive refundable tax credits, depending on the number of children in the household.

In addition to the federal government, many states that levy income taxes also offer tax credits. These tax credits vary by state but often mirror the tax credits offered by the federal government.

There are a wide variety of credits you can claim. Let Bankrate help you navigate them.

Tax credit example

A taxpayer with one qualifying child in the 2016 tax year received up to $3,373 as a tax credit. Ezekiel earned $30,000 during the 2016 tax year, and after accounting for all deductions, he had a tax bill of $2,810, but paid $4,500 in income tax payroll deductions. Ezekiel qualified for the maximum earned income tax credit, and received a tax refund of $5,063.

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