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What Is a Tax Credit?

Tax credits reduce your taxes, sometimes below zero. These tax credits can put money in your pocket—if you behave in certain ways believed to be good for America.

By Mike Azzara | American Express Credit Intel Freelance Contributor

5 Min Read | July 13, 2020 in Life

 

At-A-Glance

Tax credits lower your tax bill directly, as opposed to deductions, which only lower your taxable income and therefore have much less impact on the taxes you owe.

Tax credits are generally tied to public policy benefits, whether to help lift working families out of poverty, lower residential energy use, increase adoption of electric cars, or encourage you to save for retirement.

Tax credit (noun): an amount of money that is subtracted from taxes owed.

—The Merriam-Webster Dictionary1

 

Want an electric car? There’s a tax credit for that. 

 

How about a college degree? There’s a tax credit for that. 

 

Solar panels on your roof? New energy-efficient windows? A day camp for your kids while you work? Retirement savings? Health care insurance? There are tax credits for all of them. There’s even a tax credit just for having kids. This is the first in a 10-part, plain-English series describing the most popular tax credits and some of their key attributes. 

 

Simply stated, a tax credit is a dollar-for-dollar reduction in the taxes you owe, just like the dictionary definition says. But Merriam-Webster’s tax credit definition doesn’t hint at tax credits’ true purpose.

 

Why Do Tax Credits Exist?

Governments the world over generally use tax credits to drive public policy initiatives. In the U.S., tax credits for individuals are all designed to work the same way: They’re government encouragement to increase certain behaviors in Americans and achieve specific goals. For example, U.S. policymakers have long believed that stable families—married couples with children—are good for the country and help to grow the economy. Ditto, education. Consequently, there are many tax credits in support of stable families and higher education. But that only scratches the surface.

 

More powerful than a deduction. Though technically not part of the tax credit definition, it’s also critical to know how much more powerful credits are than deductions, as monetary incentives go. A $2,000 tax credit comes right off your tax bill, lowering it by $2,000. A $2,000 deduction lowers your taxable income. If you’re income is low—say, in the 10% tax bracket—that deduction takes $200 off your tax bill (10% of $2,000). If you’re in the top tax bracket—which means income above half-a-million a year—that deduction takes $740 off your tax bill (37% of $2,000). This example is for illustration only, since everyone’s real tax rate is actually a more complex calculation (For more, read “How to File Taxes”). Adding to their power, all the tax credits you’re eligible for can usually be combined.

 

But due to confusion or simple lack of awareness, many people who are eligible for tax credits never claim them. 

 

So, we assembled this series, explaining in plain English how tax credits work and then taking deeper dives into some of the popular individual tax credits—in equally straightforward language. You’re reading Part 1. The others are: 

 

Part 2: How They Work

Here’s a more detailed explanation of the tax credit process, including what the most popular credits are for and which tax forms you’ll need to use to claim them. Read “How Tax Credits Work.”

 

Part 3: Refundable Tax Credits

Learn how some tax credits—called “refundable”—can get you money from the IRS even if you didn’t pay them any taxes! Meanwhile, nonrefundable credits can reduce your taxes to zero—but no more. Read “What Are Refundable Tax Credits?

 

Part 4: Earned Income Tax Credit

To increase workforce participation and reduce poverty among low-income working families, this tax credit could put a maximum of about $6,500 in your pocket. It phases out between $15,600 and $56,000 in annual income, depending on whether you’re single or married and how many children you have. Read “What Is the Earned Income Tax Credit?

 

Part 5: Child Tax Credit

The Child Tax Credit can take up to $2,000 off your federal income tax bill for every child (or other qualified dependent) you have. And your income can be as high as $200,000 (if you’re single) or $400,000 (if you’re married) before it starts to phase out. Read “What Is the Child Tax Credit?

 

Part 6: Childcare Tax Credit

Completely different than the Child Tax Credit, the Child and Dependent Care Tax Credit offsets between 20% and 35% (depending on income) of your qualified childcare expenses so that you can work. You can get a maximum credit of $1,050 to offset one child’s care expenses, or $2,100 for two or more. Read “What Is the Childcare Tax Credit?"

 

Part 7: Electric Vehicle Tax Credit

Up to $7,500 back on the price of plug-in electric cars. This tax credit is alive and well, despite some confusion to the contrary. It phases out for each car maker once that company sells 200,000 electric vehicles, so cars from all but two car companies still qualify. Read “What Is the Electric Vehicle Tax Credit?

 

Part 8: Health Care Tax Credit

Its official name is the Premium Tax Credit because it pays some or all of your family’s monthly health insurance premium (depending on your income) if you buy insurance from one of the state health marketplaces. Read “What Is the Health Care Tax Credit?

 

Part 9: Education Tax Credits

If you or your dependent pursue education after high school, you may be able to get one (but not both) of two different education tax credits: the American Opportunity Credit (max of $2,500 per student) and the Lifetime Learning Credit (max of $2,000 per tax return). Read “What Is the Education Tax Credit?

 

Part 10: First-Time Home Buyer Tax Credit

It may be too late for most people to get the federal version of this credit, but several states offer financial incentives for first-time home buyers. Plus, there are plenty of other tax advantages that new homeowners can seek. Read “Can First-Time Home Buyers Get a Tax Credit?

 

The Takeaway

A large variety of federal tax credits can get you money back from the IRS for a broad range of social good, from having children to pursuing higher education to buying electric cars. This plain-English series explains what tax credits are, how they work, and key points you need to know about each of the most common credits.

Mike Azzara

Mike Azzara has covered technology and financial services issues for more than 30 years as a writer, editor, publisher, consultant, and analyst for media brands, startups, and established corporations.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

The material made available for you on this website, Credit Intel, is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.