Young man doing taxes.

What Are Tax Credits?

Sarah Sharkey3-minute read
July 01, 2021

Tax credits can help you to significantly reduce your tax bill each year. 

If you’re wondering exactly what tax credits are, that’s a completely fair question. It can be confusing to untangle the jargon surrounding filing your taxes. Don’t worry! We’ll walk you through exactly what a tax credit is below.

What Are Tax Deductions And Credits?

First, you need to distinguish between a tax credit and a tax deduction. 

A tax deduction is an amount of money that you can subtract from your taxable annual income. You have the choice to take the standard deduction offered by the IRS or itemize your tax deductions on an annual basis. For example, you might deduct business expenses or your mortgage from your taxable income.

Let’s say you earned $100,000 for the year but choose to take the standard deduction of $12,200. That would leave your taxable income at $87,800. At this point, you would only pay taxes on the $87,800. The percentage you pay will be based on the tax bracket you fall into after your tax deductions. 

A tax credit is an amount of money that you can subtract from your tax liabilities. If you owed $10,000 in taxes but have a tax credit for $6,000, then you would only be required to pay $4,000 in taxes that year.

What Is A Tax Credit And How Does It Work?

Now, you might be wondering, “How do tax credits work?” After all, subtracting credits from your tax liability sounds great, but how does that work in practice?

Essentially, a tax credit is a tax break that will reduce your total tax bill. You can claim tax credits on both your state and federal taxes. 

After you determine what tax credits you qualify for, you can subtract them from your tax bill. In some cases, you’ll still have some taxes to pay. In other cases, you might even get a refund. However, not every tax credit is a refundable credit. You may only be able to reduce your tax liability to zero without receiving a check in the mail. 

If you qualify for refundable tax credits, then you can receive a refund check for part of your tax credit. For example, let’s say you owed $1,000 in taxes, but received a refundable tax credit of $2,000. That means you would receive a check from the IRS for $1,000.

What Qualifies As A Tax Credit?

Tax credits come in all shapes and sizes to help taxpayers dealing with a wide variety of scenarios.

Let’s take a closer look. 

Types Of Tax Credits

A few types of tax credits include:

  • Lifetime Learning tax credit. If you are currently in school, you can use this tax credit to offset some of your education fees. 
  • American Opportunity tax credit. This is another education tax credit that aims to reward taxpayers for enrolling in higher education. You’ll need to be in school at least half time to qualify. 
  • Child tax credit. The child tax credit aims to help families caring for children in their home. 
  • Adoption tax credit. If you’ve adopted a child this year, then you might qualify for this credit to help offset your high adoption costs. 
  • Energy tax credit. You can be rewarded with a tax credit for installing solar energy systems in your home. 
  • Earned income tax credit. This credit will vary widely based on your income and marital status.  

These are just a few types of tax credits that you might qualify for. In order to find out more, it’s a good idea to talk to a tax professional. They can help you determine whether you qualify for a range of tax credits. Plus, they might help you find one that you didn’t even know existed!

Tax Credit Refund

Once you determine your tax credits and file your taxes for the year, you might receive a tax refund check. It can be an exciting day when you actually receive a check in the mail from the IRS. Whether it’s a few hundred dollars or a few thousand, take advantage of this opportunity to improve your financial situation. 

Think about your long-term financial goals. If you have any debts, consider paying them down with your tax refund. If you want to buy a home, then use the funds to build your down payment. Or consider investing the funds into your retirement plan

Whatever you choose to do with your refund, make sure that it furthers your long-term financial goals. Although spending the entire check on a nice night out could be fun, it might not be worth it in the long run.

The Bottom Line

Tax credits can help you decrease your tax liabilities. Not only can you eliminate your tax burden, but you can potentially receive a refund! Take advantage of the opportunity to improve your finances with those extra funds. If you aren’t sure where to get started, then check out RocketHQSM for some credit-building tips!

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Sarah Sharkey

Sarah Sharkey is a personal finance writer that enjoys helping readers learn more about their finances. She has an MS in Business Management from the University of Florida. You can connect with her on LinkedIn or Instagram @adventurousadulting.