When it comes to saving money on your taxes, tax credits are one of the most valuable available methods. Tax credits are subtracted dollar for dollar directly from the amount of tax you owe the IRS.
These credits are incentives that the government gives for behaviors or actions that they deem beneficial, like taking care of dependents, buying an environmentally friendly electric car or earning an income.
How tax credits work
Tax credits, as opposed to tax deductions, are subtracted directly from the tax you owe, helping you cut down your overall tax bill. Tax deductions simply lower your taxable income.
Let’s say that you make $50,000 and owe $10,000 in taxes (this is simplified from real progressive tax rates). If you take a tax deduction of $1,000, you’d owe taxes on $49,000 of income instead of $50,000, and your tax bill would be about $9,800. A $1,000 tax credit, however, comes right out of the bill, so instead of owing $10,000 in taxes, you’d owe $9,000.
Because tax credits are subtracted directly from your tax bill, there aren’t very many of them. Knowing what tax credits that you qualify for can create substantial savings on your taxes. The IRS offers three types of tax credits.
Types of tax credits
- Non-refundable tax credits: These credits allow you to use up to the amount that you owe. So if your tax bill is $1,000, but you qualify for a non-refundable $1,200 tax credit, you’d only get your taxes reduced to zero. (Your $1,200 tax credit would be capped at $1,000.)
- Refundable tax credits: On the other hand, refundable tax credits can put cash back in your pocket. If you get a refundable $1,200 credit on a $1,000 tax bill, you’ll receive a payment of $200 for the rest of the credit. In short, you’d get a refund from the IRS.
- Partially refundable tax credits: The combination of these two are credits where only part of the credit is refundable. So, if you had a $1,200 credit where only $1,100 was refundable, you’d only get the last $100 refunded if you had that same $1,000 bill.
Popular tax credits and how to qualify for them
Popular tax credits include expenditures for large renewable energy or energy efficiency purchases, costs related to raising a child or dependent care, and credits for saving or educational expenses.
Energy efficiency and renewable energy upgrades
Plug-In Electric Drive Vehicle Credit: For eligible plug-in electric vehicles that you purchase new, the current tax credit is up to $7,500, or 10 percent of the purchase price. Some factors, including the capacity of the battery, impact whether you qualify for the full amount, so check this list for the car you’re considering or have purchased. In addition, the tax credit begins to phase out once an electric car maker sells 200,000 vehicles. Tesla electric vehicles, for example, are no longer eligible for the federal tax credit.
Residential Energy Efficient Property Credit: The government offers a percentage credit to incentivize home improvement purchases that are considered sustainable and energy efficient, such as solar energy systems. If you purchased and placed the qualifying improvement into service before the end of 2020, your credit is 26 percent, while improvements placed into service by the end of 2021 received only 22 percent. Items that may qualify include solar electric, solar water heaters, geothermal heat pumps, small wind turbines, and fuel cells.
Tax credits related to dependents and children
Child Tax Credit: When you fall beneath particular income limits (under $400,000 if married filing jointly, under $200,000 for everyone else), each dependent qualifying child in your care creates a $2,000 tax credit, and each non-child dependent creates a $500 nonrefundable credit. However, only $1,400 of each child’s credit is refundable if the taxpayer owes no tax.
Adoption Credit: The expenses associated with adopting a child can be high, and the credit offered by the federal government toward these adoption expenses, when they are qualifying, is $14,300 in 2020 and $14,440 in 2021. It’s non-refundable, but you can roll over what you don’t use to a future year if your circumstances and tax liability allow it. There are also circumstances where an adoption is classified as having special needs, where you may be able to claim the full credit without incurring that many expenses.
As with other tax credits, this one includes a phaseout, where you get less of a credit and eventually no credit as your income rises. The 2020 phaseout starts with adjusted gross incomes over $214,520 in 2020 and $216,660 in 2021.
Child and Dependent Care Credit: If you receive child or dependent care that falls under the rules set out by the IRS, a percentage of your first $3,000 in expenses could create a tax credit ($6,000 if you have two or more children/dependents in care). The calculation tends to yield a credit that is 20 to 35 percent of your qualifying childcare expenses.
Earned Income Tax Credit: This credit helps low- to moderate-income workers and families get a tax break, according to the IRS. This credit isn’t exclusive to those with dependents and children. It’s a credit for lower-income earners and depends on the amount of people you’re supporting. If your adjusted gross income is less than $56,000, and you have three or more children as a married couple, for instance, you’ll qualify for EITC. But with fewer dependents, you’ll need to have lower income, according to the IRS. For no qualifying children, your credit would be $538 this year, and with three or more, you’d get the maximum credit of $6,660. This credit is completely refundable, so if you don’t owe any taxes at all, you’d still get the full amount of your tax credit as a refund.
Tax credits for saving and investing
Saver’s Credit: If you have a modest income (under $65,000 when filing jointly as a married couple, $48,750 as a head of household, or $32,500 if filing single) you can get a credit for saving in a retirement plan, like a company 401(k) 403(b), or personal IRA. The credit ranges from 10 to 50 percent of up to per individual ($4,000 as a couple). The tax credit percentage is higher for lower-income filers.
Tax credits for educational expenses
For both of the educational expenses credits, there are income-based phaseouts, but most people should at least check to see if they qualify if they have educational expenses in a given year. No individual can take both tax credits in a year, but if two members of your household have educational expenses, you might be able to take both on a single tax return. (It can be the parents who take these credits if their dependent is creating the qualifying expenses.)
Lifetime Learning Credit: A credit of up to $2,000 per tax return for expenses related to an accredited school, but they don’t have to be degree-seeking.
American Opportunity Credit: If you have educational expenses and fit the income eligibility, you may qualify for up to $2,500 in tax credits based on expenses like tuition, books, supplies, and fees at an educational organization. This is focused on the first four years of schooling.