How Tax Credits Work

Tax credits are payments offered by the government that shave money off your tax bill, dollar-for-dollar. Some tax credits are refundable which means you can get the money back even if it is more than the taxes you owe. Other tax credits are nonrefundable, which means they can only reduce your tax bill to zero, but they are still much more valuable than tax deductions, which only lower your taxable income.

 
Think about this: even if your earnings are lower than the threshold to file for income taxes, by not filing you could be missing out on a tax credit that might refund you money. That’s what I call “under-filing.” For example, the IRS estimates that 20% of taxpayers who are eligible for the Earned Income Tax Credit don’t claim it, even though it might get them a refund worth thousands of dollars.¹

In general, how tax credits work is simple. You look up the requirements for a particular tax credit – the most common ones are listed below – and see if your circumstances match the eligibility requirements. If so, you fill out Schedule 3 of Form 1040, which is required for all tax credits, plus the appropriate form for that credit. You can apply for as many tax credits as you’re eligible for, and they’re all combinable.

To help get you started, I’ve listed some common tax credits, the IRS forms you’ll need to claim them, and the supporting documents to have handy as you go through the steps. Even if you’re not a do-it-yourselfer, like my husband and me, it helps to get organized for your meeting with your preparer or for your afternoon date with online tax software.

 
Earned Income Tax Credit: This fully refundable $6,728 maximum credit is for working people who earn less than $57,414 in 2021.² You get more from it if you’re married and/or have kids.

• Form needed: Schedule EIC.
• Supporting documents: Social Security numbers for each qualifying child, the amount of time any child lived away from you during the year, the amount of any investment income, Schedule E if you have supplemental income/loss and Schedule SE if you have self-employment income.
• For more, read “What Is the Earned Income Tax Credit?”

Health Care Tax Credit (aka Premium Tax Credit): A fully refundable credit meant to help you pay monthly health insurance premiums for those enrolled in a qualified health plan offered through a Health Insurance Marketplace.³ In 2021, certain income limits, including receipt of unemployment benefits, have been put into place using a sliding scale based on family size.

• Form needed: Form 8962.
• Supporting documents: Form 1095-A, which is a Health Insurance Marketplace statement confirming your insurance, Social Security numbers for your dependents.
• For more, read “What Is the Health Care Tax Credit?”

Child Tax Credit: Sweeping changes were made to the child tax credit meant to offset costs of raising a child. For tax-year 2021, this tax credit is $3,600 for children under age 6 – up from a maximum of $2,000 in prior years – and $3,000 for those under age 18.⁴ It’s also fully refundable instead of only partially refundable, as in past years, and it phases out in two steps based on income.

• Form needed: The worksheets in IRS Publication 972 will help you determine if you’re eligible, and if so use Form 8812.
• Supporting documents: Social Security or Taxpayer Identification Numbers for each child, W2s for you and your spouse, and IRS Letter 6419 showing any advance payments received during 2021.
• For more, read “What Is the Child Tax Credit?”

American Opportunity Credit (aka Education Tax Credit): This credit for qualified higher education expenses maxes out at $2,500, 40% of which is refundable (up to $1,000 per eligible student).⁵

• Form needed: Form 8863.
• Supporting documents: Form 1098-T (tuition statement from your educational institution), Social Security numbers for each qualifying student.
• For more, read “What Is the Education Tax Credit?”

Lifetime Learning Credit (another Education Tax Credit): This nonrefundable credit is broader than the American Opportunity Credit but is worth less. It maxes at $2,000 per tax return, for expenses from many different levels of education and job training.⁶ The 2021 income levels at which this credit phases out were raised significantly, making it available to more people.

• Form needed: Form 8863.
• Supporting documents: Form 1098-T, Social Security numbers for the qualifying student(s).
• For more, read “What Is the Education Tax Credit?”

Electric Vehicle Credit: This nonrefundable credit is worth up to $7,500 for purchasers of qualifying electric cars.⁷

• Form needed: Form 8936.
• Supporting documents: Manufacturer’s Certification Statement, vehicle registration.
• For more, read “What Is the Electric Vehicle Tax Credit?”

Credit for Child and Dependent Care Expenses: This credit, for costs paid for dependent care so that you can work, was significantly increased for 2021 and became refundable. The 2021 credit is up to $4,000 for one child and $8,000 for two or more.⁸ It phases out based on income.

• Form needed: Form 2441.
• Supporting documents: Social Security numbers for each qualifying dependent, Form W-10 Dependent Care Provider Identification and Certification from each care provider or name, address and Social Security numbers of any providers, W2s if you or your spouse received dependent care benefits from your employer.
• For more, read “What Is the Childcare Tax Credit?”

Retirement Savings Contribution Credit (aka Savers Credit): A nonrefundable tax credit up to $2,000 for married couples or $1,000 for everyone else who make eligible contributions to a retirement account.⁹ It phases out based on income.

• Form needed: Form 880.
• Supporting documents: Statements from your IRA, ABLE or employer-sponsored retirement accounts.

All the forms and instructions you need can be found on the IRS’ website plus many libraries, post offices, copy centers, and office supply stores. If you use a paid tax preparer, make sure you discuss tax credits as part of your filing. If you use an online filing service, its embedded tools lead you through sets of questions to help identify if you’re eligible for any tax credits and populate the appropriate completed forms.

The IRS offers a free tool on its website, the Interactive Tax Assistant (ITA), that can determine if you’re eligible for any tax credits by asking some very easy, guided questions. At the end the ITA provides links to the appropriate forms or you can take advantage of IRS Free File and Fillable Forms. Free File is free tax software and electronic filing programs for taxpayers with income below $72,000.¹⁰ Fillable Forms are electronic versions of all the IRS paper forms that does all the math automatically and are available to everyone.

For free, full-service, tax return preparation, consider the Volunteer Income Tax Assistance or Tax Counseling for the Elderly programs if your income is below $57,000 or if you’re older than 60, respectively.¹¹

The Takeaway