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Tax credits are incredibly valuable when it comes to saving money on taxes and are subtracted dollar for dollar directly from the amount of tax you owe the IRS. These credits are used to incentivize citizens to help others, whether it is by taking care of dependents or buying an electric car.
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 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 you qualify for can create substantial savings on your taxes.
Types of tax credits
The IRS offers three 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.
Most of these tax credits include a phaseout, where you get less of a credit and eventually no credit as your income rises. Be sure to check with the IRS or your tax preparer to see if you qualify based on your wages.
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 impact your eligibility to receive the maximum amount, including the capacity of your car’s battery. 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 singles), each dependent qualifying child in your care creates a $3,600 per child under age 6 and $3,000 for each child between the ages of six and 17 — up from $2,000 tax credit previously, with each non-child dependent creating a $500 nonrefundable credit. However, only $1,400 of each child’s credit is refundable if the taxpayer owes no tax. These income thresholds are based on your modified adjusted gross income (MAGI).
Adoption Credit: The expenses associated with adopting a child can be high, and the federal government offers credit toward qualifying expenses. These credits are $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.
The 2020 phaseout starts with modified adjusted gross incomes over $214,520 in 2020 and $216,660 in 2021. The credit goes away completely for those with incomes above $254,520.
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 $4,000 in expenses could create a tax credit ($8,000 if you have two or more children/dependents in care). This is up from $3,000 for one qualifying person and $6,000 for two or more prior to the passing of the American Rescue Plan Act of 2021. The calculation tends to yield a credit that is 20 to 35 percent of your qualifying child care expenses. To use this credit, you can’t also use a flexible spending account to pay for dependent care. Speak with a tax advisor or a qualified financial planner to get advice on your specific situation.
Earned Income Tax Credit (EITC): This credit helps low- to moderate-income workers and families get a tax break. 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 $1,502 in 2021 — up from $538 in 2020. With three or more, you’d get the maximum credit of $6,728, up from $6,660 in 2020. 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 $66,000 when filing jointly as a married couple, $49,000 as a head of household or $33,000 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 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. This is a non-refundable credit and is calculated as a 20 percent credit on the first $10,000 of qualified education expenses.
American Opportunity Credit: If you have educational expenses and fit the income criteria, you may qualify for up to $2,500 in tax credits based on expenses like tuition, books, supplies and fees accrued while attending your institution. This is focused on the first four years of schooling. This credit can only be used for four years per student and is a partially refundable credit, up to a maximum $1,000 refund. The amount of the credit is 100 percent of the first $2,000 of qualified education expenses per student and then 25 percent of the next $2,000 of qualified education expenses you paid for that student. The refundability is calculated as a 40 percent refund of the remaining credit after the credit zeros out a taxpayer’s tax liability.