Understanding Tax Credits

Tax credits reduce the amount of income tax you owe to the government, both federal and state dollar-for-dollar. Tax credits are offered as a reward for stimulating the economy, the environment, or other governmental concerns in a beneficial way. Most tax credits cover expenses that are paid during the year, however there are certain requirements that must be met to qualify to claim the credits.

How Do Tax Credits Affect My Return?

If you owe income tax, credits will reduce the amount dollar-for-dollar. That said, a taxpayer who owes $1,000 in taxes to the federal government, yet claims a $1,000 tax credit that he is eligible for, will end up not having to pay any tax at all. There are even some credits that are fully refundable, returning any excess amount after the tax liability is reduced to zero back to the taxpayer. For example, a taxpayer owing $400 in taxes and claiming $1000 in a refundable tax credit will receive $600 back.

Different Types of Tax Credits

There are a variety of tax credits available which account for many different types of expenses. For example, if you purchase solar panels or wind turbines for your home or property, the federal government offers a credit to offset the cost of these environmental-friendly devices. There’s also a federal adoption credit for families who choose to adopt a child, as the process can be expensive. And once you have children, raising them can be costly, which is why there’s also tax credits to help with child and dependent care. Taxpayers purchasing their first home can get a credit as well.

Credits Vs. Deductions

When it comes to saving more, credits are the way to go over deductions. Deductions subtract from the income amount that you are taxed upon, while credits actually decrease the amount of tax you owe. A taxpayer with taxable income of $50,000 with a total of $10,000 in deductions would be taxed on only $40,000 of income. At a taxable rate of 25%, the $10,000 deduction is worth around $2,500, whereas a tax credit of $10,000 actually is worth the $10,000 in savings.

State Tax Credits

Some states tax residents’ incomes, and in many situations, offer state-level tax credits as well. Californians may qualify for a renter’s state tax credit, if they make less than a certain threshold and meet other state requirements. There are other state credits that use the federal credits as a guide for their own version of the tax credit. Twenty-three different states and the District of Columbia offer a state version of the federal earned income credit.