What is a tax credit?
January 5, 2023 9 min read
When you file your federal tax return, you’ll add up your taxable income, credits, deductions, adjustments and payments to determine whether you owe money or get a refund. Tax credits can reduce how much you have to pay—or increase how much you can get back.
State and federal governments often create tax credits to support taxpayers, such as parents, and reward certain behaviors, like buying an electric vehicle. Knowing which credits are available and how they work can be an important part of tax planning.
- Tax credits can reduce how much you have to pay in taxes or increase your refund.
- To claim tax credits, you’ll need to meet the requirements and file a tax return.
- Tax deductions reduce your taxable income and may reduce your tax liability.
Tax credits vs. tax deductions: What’s the difference?
Both tax credits and tax deductions can reduce how much someone owes in taxes, but they work differently and apply to various situations:
- Tax credits reduce your tax liability on a dollar-for-dollar basis. For example, if you owe $2,000 in taxes and qualify for a $1,000 tax credit, the credit can cut your bill in half, and you’ll only owe $1,000. Some tax credits can also increase your tax refund.
- Tax deductions reduce your taxable income and can reduce your tax liability. For example, if you have a deduction worth $1,000 and you’re in the 22% tax bracket, the deduction may reduce your income taxes by $220. But a deduction won’t help you if you don’t owe any income taxes.
Types of tax credits
Tax credits are generally categorized as refundable, nonrefundable or partially refundable. With a refundable tax credit, taxpayers can receive the full amount to offset what they owe and even increase their refunds. You can qualify for refundable tax credits even if you don’t owe anything or if your income isn’t high enough to file a tax return. But you would need to file a return to claim the tax credits.
A nonrefundable tax credit can reduce someone’s tax liability, but it won’t necessarily increase their refund. If they don’t owe a lot of income tax, they may have to forfeit the portion of the nonrefundable tax credit they can’t use. But some tax credits let you carry over the unused portion to future years.
With partially refundable credits, a portion of the credit’s potential value may be used.
Types of tax deductions
Tax deductions can be above or below “the line,” which is a reference to adjusted gross income (AGI).
Above-the-line deductions, also called adjustments to income, can lower your AGI. And that may affect which tax credits you qualify for. Above-the-line deductions can be for things like student loan interest payments and educator expenses. Contributions to tax-advantage accounts, such as health savings accounts, individual retirement accounts, 401(k) plans and 403(b) plans, can also lower your AGI.
Below-the-line deductions can lower your taxable income, but they don’t impact your AGI. The most common is the standard deduction, although not all taxpayers can claim it. Alternatively, there are itemized deductions, which include deductions for mortgage interest payments, state and local taxes and charitable donations.
Common tax credits
Earned income tax credit
The earned income tax credit (EITC) is a refundable tax credit for low-to-moderate-income workers. To qualify, you must meet all the eligibility requirements and file a federal tax return. Depending on income and family size, the maximum EITC could be worth $560 to $6,935 for the 2022 tax year.
Some people who qualify for the EITC don’t claim it—and lose out on the money—because they don’t file a tax return. Keep in mind that even if you aren’t required to file a tax return based on your income, you need to file a return to claim the credit.
Child tax credit
The child tax credit is for parents and guardians of eligible children. Qualifying children can include relatives such as a stepbrother, half sister, niece or grandchild. Each qualifying child must have a Social Security number that’s valid for employment, and the child must be claimed as a dependent on tax returns.
The tax credits are typically worth up to $2,000 per qualifying child under 17 years old. The amount you can receive is based on your income, and the credit is partially refundable.
You may also be able to receive a tax credit of up to $500 for children you claim as dependents but who don’t qualify for the child tax credit. That can include children who don’t have a Social Security number or aren’t under 17.
American opportunity tax credit
The American opportunity tax credit (AOTC) is an education tax credit that eligible students can claim for qualifying expenses at a postsecondary school. These include tuition, fees and required expenses, such as textbooks. The tax credit is worth up to $2,500 each year per student, and it’s partially refundable. So if your tax liability is $0 after using some of the tax credit, you could receive 40% of the tax credit that’s left.
To claim the credit:
- You, your spouse or your dependent must be enrolled at least half time at an eligible educational institution.
- The student can’t have a felony drug conviction.
- The student must be in their first four years of higher education.
- The student can’t have already claimed the AOTC—previously the Hope credit—more than four times.
- You need a Form 1098-T from the school.
The retirement savings contributions credit, or saver’s credit, is a nonrefundable tax credit for low- and moderate-income taxpayers. The credit is worth up to $1,000—or $2,000 if you’re married and file jointly.
You may qualify if:
- You’re 18 or older.
- You aren’t a student.
- No one claims you as a dependent on their tax return.
- You make eligible contributions to your retirement accounts, including traditional and Roth IRAs and employer-sponsored retirement plans, such as a 401(k) or 457(b). Contributions to Achieving a Better Life Experience accounts also qualify if you’re the beneficiary.
Depending on your AGI and filing status, the credit could be worth up to 50% of the amount you contribute to your account.
Solar tax credit
The solar tax credit is related to buying and installing solar power systems. Although the credit is nonrefundable, you can roll over credits that you qualify for but don’t use until the following tax year.
The Inflation Reduction Act of 2022 extended and expanded this federal tax credit. The credit is now worth 30% of eligible expenses from 2022 through 2032, including the cost of:
- The solar panels, photovoltaic cells and required equipment to set up your system
- Energy storage devices that can store at least 3 kilowatt-hours
- Labor, fees and inspections
- Sales tax
There are no income requirements, and there’s no cap on how much the credit is worth, but there are other requirements. For example, you need to buy and own a new system and install it at your primary or secondary residence. Or you may qualify if you buy into an off-site community solar project that supplies power to your home.
Clean vehicle tax credit
The qualified plug-in electric drive motor vehicle credit—now known as the clean vehicle credit—is for taxpayers who purchase clean vehicles such as electric, plug-in hybrid and hydrogen fuel cell vehicles. The Inflation Reduction Act of 2022 extended the tax credits through 2032, phasing in new rules from 2023 to 2025. Starting in 2023, taxpayers can get a credit worth up to $7,500 for purchasing a new clean vehicle and up to $4,000 for buying a used clean vehicle.
To qualify for the credit, your AGI must be below the limit, which varies depending on your filing status. The vehicle also has to meet certain requirements. For example, a new vehicle’s final assembly must be done in North America. And it can’t have a manufacturer’s suggested retail price above $80,000 for SUVs, vans and pickup trucks—or over $55,000 for other vehicles. For used clean vehicles, you must buy the vehicle from a dealer for less than $25,000, and it has to be the first time that the vehicle is resold.
What’s the difference between federal and state tax credits?
Federal tax credits can affect your federal tax return and federal income taxes. States may also have tax credits that you can claim to decrease how much you owe or increase your refund when you file a state tax return.
For example, most states have earned income tax credits that are like the federal EITC. Similar to federal tax credits, states may choose to make the credit refundable or nonrefundable. The state credits are also often either a percentage of your federal EITC or a flat amount based on your filing status and family size.
Are tax credits only for individuals?
State and federal governments also offer tax credits to businesses. Similar to individual tax credits, these can reduce a business’s tax liability.
For example, companies that experiment with the goal to develop or improve various products and processes may qualify for the federal research and development tax credit. The credit can reduce a company’s tax liability. Some states also offer a similar state tax credit.
Other tax incentives for businesses
Businesses can also benefit from various tax deductions and incentives. For example, eligible businesses in New York that partner with a state college or university and create new local jobs may be exempt from state taxes for up to 10 years through the START-UP NY incentive program.
At the federal level, businesses can deduct eligible expenses. And these sometimes also apply to sole proprietors like consultants, gig workers and contractors who don’t form a business entity. For example, if you use your home or vehicle for business, you may be able to deduct a portion of your expenses.
The rules and requirements can be tricky, but the IRS’s site breaks down various business expenses, how the deductions work and what you’ll need to qualify for each one. Consider consulting with a tax professional if you have business income or decide to start a new business.
Tax credits in a nutshell
Tax credits can reduce your tax liability or increase your refund on a dollar-for-dollar basis rather than lower your taxable income like deductions do. However, you’ll need to meet the requirements for each tax credit, submit any associated forms and file your tax return to claim the credit. If you expect to receive a refund, you can learn more about taxes while you wait for it.