Let’s talk tax credits. Ignoring every other complicated equation and factor, your tax bill really comes down to two things: how much you’ve earned and how many expenses you’ve accrued.
On the earning side, your income serves as the main factor. If you have one primary source of income, that will dictate how much you may owe in taxes. If you own an investment property, the income from that property will factor into your total tax obligation. And if you’re self-employed, the total income from each client will factor into your overall income.
On the expenses side, loosely speaking, certain expenditures throughout the year can be written off or reimbursed by the IRS. Depending on your income, there are a ton of education expenses, healthcare or childcare expenses, business expenses, and other costs that the IRS is willing to count as tax deductions or tax credits.
While tax credits and tax deductions can both help you save during tax season, they function differently, and you should understand the specifics when it’s time to file your taxes. In this article, we’ll cover the different types of tax credits.
When claiming a tax credit, it’s important to know whether or not that credit is refundable.
The difference between refundable and nonrefundable tax credits can amount to thousands of dollars. To explain the difference, we’ll first cover what makes tax credits different from tax deductions, then describe how each type of tax credit works.
Most people use the terms “tax credit” and “tax deduction” interchangeably, but despite their similarities, they’re different in a crucial way.
Both tax credits and deductions impact your tax bill. And depending on your taxable income, both can help you lower how much you owe in taxes, or help you end up paying $0 in income altogether.
While both credits and deductions can both lower your tax bill and are, therefore, ultimately awesome, how they lower your tax bill is an important difference.
Tax deductions lower your taxable income. Every dollar you earn is subject to tax, but when you claim a tax deduction, that total is lowered. Specifically, the total is lowered by the percentage of your highest federal income tax bracket.
Example: Let’s say your total income was $100,000. If you fall into the 25% tax bracket, a $10,000 deduction will reduce your taxable income by $2,500.
Tax credits reduce the total amount of tax you owe. Rather than just impacting your taxable income, tax credits lower your tax liability. When you claim a tax credit, you reduce your tax liability dollar-for-dollar.
Example: Let’s say your total income was $100,000. If you fall into the 25% tax bracket, a $10,000 credit will reduce your taxable income by $10,000.
And now, the moment you’ve been waiting for. What in the heck is the difference between a refundable tax credit and a nonrefundable one?
Simply put, refundable credits are credits that can result in a tax refund.
For example, the Earned Income Tax Credit can provide a reduction in your total tax liability. Should that total lower you below $0 owed, you’ll receive a tax refund. Or, if you owe $200 in taxes and claim a $1000 refundable tax credit, you can receive a tax refund of $800. With refundable tax credits, you can reduce a high tax bill down to a much more manageable tax bill, down to $0, or even beyond.
Nonrefundable credits don’t go quite as far as refundable credits, because they can’t result in a tax refund.
For example, if you owe $200 in taxes and claim a $1000 refundable tax credit, you’ll reduce your tax bill to $0—but not beyond. So, you won’t necessarily get a refund. With nonrefundable tax credits, you can reduce a tax bill on a dollar-for-dollar basis down to a more manageable tax bill, but not beyond $0.
In many ways, qualifying for tax deductions is easier than qualifying for tax credits—and you need to keep that in mind if you’re planning to claim a credit on your tax return.
Each tax credit has its own set of qualifications, ranging from income thresholds to filing status to credit-specific qualifications. For example, the American Opportunity Tax Credit and the Lifetime Learning Credit both reduce the costs of higher education, but in different ways. You may even qualify for one and not the other! Be sure to know exactly how your preferred tax credit works before you attempt to claim it. You could end up on the receiving end of a tax bill—or an audit.
There’s actually a second thing all tax credits have in common: You’d definitely rather be able to claim one than not. That’s why you should know the differences between refundable and nonrefundable tax credits—so you can claim accordingly.
Of course, finding the right tax credits to lower your tax liability and maximize your tax refund is just a part of what we do. So, how about we get started on your tax return today?
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