Introduction
Taxes are an essential part of any economy, but to lighten the burden on citizens, most governments offer tax credits to various sectors of society. Tax credits work differently than tax deductions, which only reduce taxable income. Tax credits, on the other hand, directly reduce the taxpayer’s tax liability. However, many taxpayers are unclear about tax credits, what they entail, and how to access them.
If you’re one of these people, this article is for you. This short guide covers the essentials of tax credits, including what they are, how they work, and how to get them.
What are tax credits?
Tax credits are tax incentives designed to reduce the amount of tax a taxpayer pays. Essentially, a tax credit is a direct reduction of the taxpayer’s amount of tax liability. The credit amount may vary based on different factors, such as the type of credit, a taxpayer’s income range, or specific circumstances.
Tax credits are available in both federal and state taxes. Some popular tax credit programs in the United States include the Earned Income Tax Credit (EITC), Child Tax Credit (CTC), and Education tax credits. The purpose of these tax programs is to encourage behavior that benefits society, such as furthering education, supporting low-income households, and protecting the environment.
Here are some more examples of popular tax credits:
1. Retirement Savings Contributions Credit: This is also known as the Saver’s Credit, designed to encourage low- and moderate-income persons to save for retirement. It’s a credit of up to $1,000 ($500 if filing separately) that the taxpayer can claim for contributions to an individual retirement account (IRA) or employer-sponsored retirement accounts.
2. American Opportunity Tax Credit: This is available to qualified education expenses, and eligible taxpayers can claim a credit of up to $2,500, making educational expenses more affordable.
3. Lifetime Learning Credit: Like the American Opportunity Tax Credit, this offers relief to students and individuals with a lower income who pay for their education. The credit amount is up to 20% of the first $10,000 of qualified education expenses (a maximum of $2,000).
4. Adoption Tax Credit: This is a nonrefundable tax credit for expenses associated with the legal adoption of a child.
5. Renewable Energy Tax Credit: For those ready to invest in renewable energy sources, they can receive a tax credit of up to 26% of the cost of installing a renewable energy system such as wind, solar, or geothermal systems.
How do tax credits work?
As previously mentioned, tax credits are designed to reduce a taxpayer’s tax bill directly. This means that the taxpayer can subtract the amount of the tax credit from the amount they owe in taxes on the income tax return.
There are two types of tax credits: refundable and nonrefundable.
Refundable tax credits are the type where if the credits exceed the taxpayer’s tax liability; the IRS will refund the difference to the taxpayer. Nonrefundable tax credits, however, cannot exceed the taxpayer’s tax liability.
For example, if a taxpayer has a $1,000 tax bill and qualifies for a $1,500 refundable tax credit, the IRS would still owe the taxpayer $500. However, if the same tax credit were nonrefundable, the taxpayer would see an overall reduction to their tax liability of $1,000.
When applying for tax credits, it’s important for taxpayers to ensure that they meet the eligibility and timing requirements for the specific credit they’re interested in claiming. It’s recommended that taxpayers do their research about tax credits early in the year to ensure they have all the documentation required to claim them during tax season.
Who is eligible for tax credits?
Any taxpayer that meets the eligibility requirements of a specific tax credit may claim it. Each tax credit program has unique eligibility requirements, but there are general categories of tax credits, such as education, homeownership, and low-income households.
For instance, taxpayers with children may be eligible for the Child Tax Credit. This nonrefundable credit offers a tax credit of up to $2,000 per eligible child under the age of 17. Additionally, taxpayers may be eligible for up to $1,400 of the credit to be refundable.
Similarly, taxpayers who work and have low to moderate incomes may qualify for the Earned Income Tax Credit (EITC). This refundable credit is based on income, family size, and filing status. For the 2021 tax year, a taxpayer could receive up to $6,728 in refundable credits under the EITC program.
Taxpayers should take some time to research tax credit programs and ensure they meet the eligibility requirements for each tax credit program they wish to claim.
How to apply for tax credits
The process of applying for tax credits depends on the tax credit program being claimed. However, there are general requirements taxpayers should meet when applying for tax credits.
First, taxpayers should ensure they have the documentation required to prove their eligibility for the tax credit program they’re claiming. For example, if a taxpayer is applying for the American Opportunity Tax Credit or the Lifetime Learning Credit, they will need to submit documents, such as school bills and receipts, to prove they’ve paid for qualified expenses.
Secondly, taxpayers should ensure they file their tax returns by the required deadline if they wish to claim a particular credit. In some cases, tax credits may not be available if claimed after the tax return is filed.
If you’re not comfortable applying for tax credits on your own or have more complex filing requirements, you can seek the help of a tax professional.
Conclusion
In summary, tax credits serve to help taxpayers reduce their annual tax bills. Taxpayers should do their research about tax credits early to ensure they benefit from available programs. Eligibility requirements may vary in different tax credit programs, and taxpayers should ensure they meet these requirements before claiming the money-saving advantage of any program.
It’s worth noting that the IRS releases updated information regarding tax credits each year; taxpayers should always check the IRS website or other reputable sources before claiming a tax credit. By following these guidelines, you can be eligible for tax credits and save significantly on your tax bills.
Tax credits can be granted for a wide variety of reasons, and can be extended to cover a broad spectrum of taxes. A tax credit can serve as a form of recognition of taxes that have already been paid, to provide a subsidy to the legal entity who is receiving the tax credit, or in order to serve as a method of encouragement to particular behaviors or to entice an investment.
Depending on the tax system under which the tax credits are granted, the tax credit may or may not be refundable, depending on whether or not the tax credit exceeds the respective tax. Different tax systems may be designed to grant a tax credit to businesses or to individuals, and these tax credits can vary according to the type of credit that is offered.
Under most tax systems, taxes that are paid indirectly, such as withholding taken out of income checks are considered tax credits, rather than being known as prepayments. The most common tax credits are payroll withholding of income tax (also known as PAYE), withholding of tax at the source of payment to non-residents, and input tax credits that are associated with a value added tax.
A tax credit is designed to provide financial compensation for a choice that has been made, or to subsidize particular course of action, such as a child tax credit, a tax credit to individuals who have completed an adoption, an earned income tax credit, a tax credit to foster retirement savings, or a variety of other tax credits.
