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

Tax credits can help reduce your tax burden and let you keep more of your money.

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

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

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 the credit.

Tax Credits versus Deductions

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

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

Nonrefundable Tax Credits

According to the Internal Revenue Service, 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.

For instance, 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, or taxes on withdrawals from individual retirement accounts and other qualified retirement plans, the IRS says. Most tax credits fall in this category.

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

The IRS notes that 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 what 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-gain 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.

With the new changes in the tax code, it’s worth working with your tax preparer to see which tax credits you may qualify for. Qualifying for credits may not make preparing your taxes any more fun, but at least they may 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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