Tax credits can help taxpayers by providing financial relief, but what is a tax credit, how do they work, and how do you claim them?
Many taxpayers may have become familiar with what tax credits are and how they function, through an energy-efficient home purchase, a first child, or through caring for an elderly loved one. Yet what really are tax credits, and how do they differ from tax rebates and deductions?
What is a Tax Credit?
Put simply, tax credits are refundable or non-refundable sums sent to a taxpayer through the IRS and the US Treasury.
All tax credits must be used to reduce your tax liability to the government. If the tax credit exceeds your tax liability, then it may be refunded if it is a refundable tax credit.
For example, the first, second, and upcoming third Economic Impact Payments (stimulus checks) are a tax rebate, or refund. This is money the government puts directly into the hands of taxpayers, without any obligation to use it towards their tax payments, even including outstanding tax debts.
Credits like the Earned Income Tax Credit, on the other hand, must first be used to pay for your taxes. Tax credits differ from deductions in that they can be claimed regardless of whether you itemized your deductions or not. They also differ in the sense that some tax credits can become refunds if they otherwise fully cover your tax liability.
Generally speaking, tax credits are meant to provide relief to taxpayers who may be facing economic hardship as a result of their circumstances. New parents, children with elderly dependents, low- to moderate-income households saving for a family member’s tuition, and those saving for retirement may be eligible for certain tax credits. Here are just a few examples of specific tax credits individuals can make use of to reduce their tax liability.
Types of Tax Credits for Individuals
Tax credits for individuals are broken down by the IRS into five separate categories:
- Family tax credits
- Homeowner tax credits
- Healthcare-related tax credits
- Education-related tax credits
- Savings tax credits
Family and Dependent Credits
Common family credits include the:
Each tax credit has its own IRS publication to walk you through the eligibility process and help you determine, at a glance, whether you would be able to use the credit during tax season that year.
As a general rule, the IRS takes into consideration:
- Your income,
- Whether you have qualified persons in your care, and
- Whether your earnings go towards covering care expenses.
The EITC is the only tax credit in this list that can be used even without children and dependents and is largely based on your income and financial circumstances.
Homeowners may qualify for the:
These credits apply to homeowners specifically, including those who own residential rental property as an investment vehicle.
Healthcare credits include the:
- Premium Tax Credit under the Affordable Care Act
- Health Coverage Tax Credit
The HCTC is exclusive to those under Trade Adjustment Assistance, or older taxpayers under the Pension Benefit Guaranty Corporation.
Eligibility for the Premium Tax Credit can be determined through the IRS’s own pre-qualification tool. It is still a good idea to speak with a tax professional about what tax credits you may qualify for.
Educational credits include the:
There are also tuition-specific itemized deductions. To determine eligibility, you would need the enrollment status of the student in the family, your filing status and AGI, as well as how and from whose income expenses were paid.
Different income-based and savings-based tax credits include the:
The Recovery Rebate Credit is a tax credit given to taxpayers who are eligible for the 2020 and 2021 Economic Impact Payments (tax rebates) but did not receive them. More accurately, the Economic Impact Payments were advance payments of the Recovery Rebate Credit. Taxpayers eligible for a stimulus check who did not receive one, or only received a partial payment, may be eligible for a Recovery Rebate Credit on their next tax bill.
The Saver’s Credit or Retirement Savings Contributions Credit is a tax credit given to qualifying taxpayers who contribute to an IRA (both Roth and traditional) or an employer-sponsored retirement plan. The credit amount is based on the taxpayer’s income, filing status, and contributions to the plan.
How to Claim a Tax Credit
Tax credits are taken into account at the very end of the tax filing process, when you’re done calculating your total tax liability and know what you owe the government.
You then subtract so-called above-the-line deductions from your gross income, remove your standard or itemized deductions from your new adjusted gross income, and finally, consider the tax credits you are eligible to receive, with the correct amounts. These credits can help some taxpayers partially or even eliminate the year’s income tax liability.
If you make a mistake on calculating your tax credits, the IRS may correct it for you (and use the rest of the credit to cover the increased liability if your bill was raised). Otherwise, the IRS will send you a notice for your adjusted tax bill, as well as a deadline to cover the outstanding balance before penalties and interest accrue. Working with a professional can help you eliminate mistakes and avoid unexpected tax costs.
Nonrefundable tax credits can only be used to lower tax liability, and do not become cash should your liability hit zero. Refundable tax credits become tax refunds once your tax liability is paid, and at least a portion of the credit goes unused.
While the IRS provides a myriad of information on individual tax credits as well as qualifying tools to help you navigate each tax credit’s eligibility criteria, it helps to revisit the topic with a tax professional. At Rush Tax Resolution, we can help you prepare your income tax return and make sure that you don’t miss out on any applicable tax credits.