What Is a Tax Credit?

A tax credit is a reduction in the overall tax that a taxpayer must remit to the government.  Tax credits differ from deductions, although both have the end result of reducing the amount of taxes that a person must pay. 

Deductions decrease a person’s adjusted gross income in order to arrive at that person’s taxable income.  Because the deductions reduce the amount of income that is subject to taxation, they have the effect of lessening a person’s tax liability, albeit indirectly.

Tax credits, on the other hand, diminish the amount of actual taxes that the person owes.  For example, suppose a taxpayer can claim a $500 tax credit.  The tax owed by the taxpayer based on their taxable income is $2,000.  The tax credit will reduce the actual tax liability, so the taxpayer will end up owing the government only $1,500.

There are two varieties of tax credit: refundable and non-refundable.  If a tax credit is refundable, it means that the government will pay the taxpayer if the credit exceeds the amount of taxes owed.  In other words, if a taxpayer can claim a tax credit of $750 but only has a tax liability of $500, the taxpayer can expect a check from the government for $250 since that is the amount of the credit that exceeds the taxpayer’s tax liability.

Non-refundable tax credits, as the name suggests, can eliminate a taxpayer’s liability entirely, but the taxpayer will not receive money back from the government if the credit exceeds the amount of taxes owed.

There are many different tax credits available to taxpayers.  See IRS Tax Topic 600 for more information.

Next Steps

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