Income Tax Credits Explained
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Learn How Tax Credits Can Reduce What You Owe
A tax credit is a dollar-for-dollar reduction in the amount of tax that you owe. For example, a $500 tax credit will save you $500 in taxes.
On the other hand, a tax deduction merely reduces your taxable income. The amount of your tax deduction is equal to the percentage of your marginal tax bracket. For example, if you are in the 25% tax bracket, a $500 tax deduction will save you $150 in taxes (because $500 x 25% = $150).
Tax credits are claimed on your income tax return — on the second page of IRS Form 1040, after you report your earnings and calculate your AGI (adjusted gross income).
For individual taxpayers, there are two main types of tax credits: refundable tax credits and non-refundable tax credits.
Non-Refundable Tax Credits
The most common tax credits are non-refundable tax credits. Non-refundable tax credits reduce the amount of tax that you owe, however, they cannot reduce your tax liability beyond zero. Additionally, non-refundable tax credits cannot be used to offset Self-Employment Tax or tax on withdrawals from IRAs and other qualified retirement plans.
Popular non-refundable tax credits include the following:
• Foreign Tax Credit
• Child and Dependent Care Credit
• Education tax credits
• Retirement Savings Credit
• Child Tax Credit
• Energy Savings tax credits
In many cases, you are required to submit a separate/additional form or schedule to verify your eligibility for a tax credit.
Your non-refundable tax credits are tallied on Lines 48–54 of Form 1040. Line 55 is the sum of your credits, and Line 56 is your tax liability after taking those credits into account. On Line 56, it says that if your total credits (Line 55) are more than your tax (Line 47), you should enter “0”.
Refundable Tax Credits
Refundable tax credits can reduce the amount you owe to beyond zero, even resulting in a tax refund. There are three popular refundable tax credits that can be found on Form 1040:
The most commonly used refundable tax credit is the Earned Income Credit (EIC). This credit is claimed on Line 66a of Form 1040.
The Additional Child Tax Credit is designed for lower income individuals who were unable to take advantage of the full Child Tax Credit because they did not owe enough tax. This credit is claimed on Line 67 of Form 1040.
The American Opportunity Tax Credit (AOTC) helps qualified taxpayers to offset the costs of higher education and is worth up to $2,500. This credit can be claimed on Line 68 of Form 1040.
Refundable tax credits are reported in the “Payments” section of your 1040 tax return, along with Federal income tax withheld and quarterly Estimated Tax payments. Since they are classified as payments, refundable tax credits can also help offset your self-employment tax and qualified retirement plan distribution tax.
Tax Forms 1040A and 1040EZ
On Form 1040A, you can claim most of the credits that are available on Form 1040. This includes the credit for child and dependent care expenses, credit for the elderly or disabled, retirement savings contribution credit, education credits, and the child tax credit. 1040A filers may also claim the Earned Income Credit, the Additional Child Tax Credit, and the American Opportunity Tax Credit.
Note that the only tax credit that you can claim on Form 1040EZ is the Earned Income Tax Credit.
Tax Credit Resources
You can use the following IRS publications to determine your eligibility for these common tax credits:
• IRS Publication 514 (Foreign Tax Credit for Individuals): PDF
• IRS Publication 503 (Child and Dependent Care Expenses): PDF
• IRS Publication 970 (Tax Benefits for Education): PDF
• IRS Publication 972 (Child Tax Credit): PDF
• IRS Publication 596 (Earned Income Credit, EIC): PDF
For more information about tax credits, please refer to Part Six of IRS Publication 17 (Your Federal Income Tax).
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