Though tax credits and tax deductions are both used to reduce your overall tax liability (the amount of tax you owe), they are not the same thing, and do not work in the same way. Tax credits are directly applied to your tax bill, meaning that the amount stated in the tax credit is directly subtracted dollar-for-dollar from your tax liability. For example, if you owe $5,000 in taxes and have a tax credit for $1,000, you now only owe $4,000. On the other hand, tax deductions work with percentages, and we explain this in more detail here.
Most tax credits are non-refundable. This means that any excess amount expires in its year of use, i.e. the additional amount is not refunded to you should there be any excess. For example, if you owe $750 in taxes but have a tax credit for $1,000, your tax liability will be reduced to zero. However, you will not receive the additional $250 as a tax refund, and the tax credit’s usefulness will end there. Refundable tax credits do exist, though they tend to be much rarer. Refundable tax credits can potentially reduce your tax liability to zero AND give you a tax refund, though this is not very common.
Eligibility for tax credits depends on many circumstances, such as your tax filing status (i.e. single or married filing jointly), employment status, age, and education status. Many college students, for example, are eligible for American Opportunity Tax Credits (AOTC) and can receive annual tax credits of up to $2,500 depending on their circumstances. Under the current system, 40% of the AOTC tax credit is also refundable.
Tax credit eligibility takes a lot of your personal and professional information into account, and it is important to verify that all the information you supply is 100% accurate and reliable. Providing inaccurate or out-dated information that makes you eligible for tax credits is considered as tax evasion, and could result in large fines or even imprisonment. Tax credits can greatly reduce your income tax, and the IRS takes great care when monitoring applications for tax breaks of any kind.
Although tax credits are less common than tax deductions, they are available for many circumstances. For example, people adopting a child or buying their first home are eligible for tax credits, as are people who are caring for an elderly parent. Child care expenses and home office expenses are also subject to tax credits, depending on your personal and professional circumstances. A number of business tax credits also exist, which may be of interest to you if you are a small or medium-sized business owner.
Tax credits are essentially designed to reward taxpayers for certain behaviors by subtracting a specific amount from their overall tax bills. Though they can be tricky to qualify for, tax credits can save you a large sum of money in tax liability over the year.