What Is a Tax Credit, Anyway? Potential Tax Burden Reduction

What Is a Tax Credit, Anyway? Potential Tax Burden Reduction

Key Takeaways

    Understand the difference between a tax credit and a tax deduction

    Learn how the type of credit (refundable or nonrefundable) might impact your tax liability

    Consider how recent changes in the tax code might affect your taxes  

Tax season is underway, which means figuring out what you owe—and finding ways to potentially reduce your tax burden.

You probably know that one way is through tax credits. But what are tax credits exactly, and how do they work?

Tax Credits vs. Deductions

First, let’s clear up any confusion between tax credits and tax deductions, because there’s an important difference. Tax deductions reduce the amount of taxable income. They depend on the taxpayer’s marginal tax rate, which rises with income, according to the Tax Policy Center. Also, any filer who takes the standard deduction isn’t allowed to take advantage of itemized deductions. But that’s not the case with tax credits.

At the most basic level, tax credits help decrease what you owe after all other deductions are considered. A tax credit reduces the amount of tax owed, dollar for dollar; your tax rate has no impact on a credit.

For individuals, tax credits fall into five general categories: family and dependents, income and savings, homeownership, health care, and education.

Nonrefundable Tax Credits

According to the Internal Revenue Service (IRS), there are two types of tax credits. The first is a nonrefundable tax credit, which means you get a refund only up to the amount you owe. These tax credits cannot reduce your tax liability below zero.

Here’s an example: If the tax credit is for $500, but you owe $300, you can only claim up to $300. (You don’t get $200 back.) Also, you can’t use nonrefundable tax credits to offset self-employment tax, nor taxes on withdrawals from Individual Retirement Accounts (IRAs) and other qualified retirement plans, according to the IRS. Most tax credits fall in this category.

What Is a Tax Credit, Anyway? Potential Tax Burden Reduction

Make taxes a little less taxing.

The key to filing taxes is being prepared. TD Ameritrade provides information and resources to help you navigate tax season.

There are several nonrefundable tax credits available to filers. Here are some of the common:

    Foreign tax creditChild and dependent care creditEducation tax creditRetirement savings creditChild tax creditEnergy savings tax credit

According to the IRS, if you file for a tax credit, you often need to include separate or additional forms or schedules to prove you qualify.

Refundable Tax Credits

The second type is the refundable tax credit. With refundable credits, if the credit is greater than the amount you owe in taxes, you get a refund. So this time, if you owe $300 and the refundable tax credit is for $500, Uncle Sam will give you a refund for the remaining $200.

One refundable tax credit related to investing is a credit for tax on undistributed capital gains. Holders of mutual funds or real estate investment trusts who paid a tax on capital gains distributions may be eligible for a credit. Other well-known refundable tax credits include the earned income credit and the American opportunity tax credit for higher education.

Refundable tax credits are classified as payments, so unlike nonrefundable tax credits, the refundable credits can help offset your self-employment tax and qualified retirement plan distribution tax.

The tax reform that went into effect beginning with the 2018 tax year included changes to some tax credits and which taxpayers might be eligible. For example, the maximum child tax credit doubled from $1,000 to $2,000 per child, and the income phaseout threshold was raised, so more taxpayers will likely qualify than in previous years.

It’s worth working with your tax preparer to see which tax credits you may qualify for. Even if you weren’t eligible for tax credits in past years, the new tax code may have changed your eligibility status.

Qualifying for credits may not make preparing your taxes any more fun, but at least credits could help take the sting out of paying Uncle Sam.

TD Ameritrade does not provide tax advice. Clients should consult with a tax advisor with regard to their specific tax circumstances.

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