Tax credits and tax deductions are both good things, but one is significantly better than the other. A tax deduction reduces your taxable income so you’ll pay a percentage tax rate on less, and that’s certainly helpful. You might even drop into a lower federal tax bracket after applying one or more of them to your gross income.
But owing less money to the Internal Revenue Service when all is said and done is even better. Tax deductions might leave you still owing $1,000 in income tax after they’ve reduced your gross taxable income to the barest amount possible. Now along comes a $2,000 tax credit that you qualify for. That credit literally erases the $1,000 you owe, dollar for dollar.
What happens to the $1,000 leftover balance depends on which type of tax credit it is. There are two: refundable and nonrefundable.
Refundable vs. Nonrefundable Credits
Almost all tax credits are designed to give a financial boost to low-income and moderate-income earners. Credits effectively reward them for doing something the federal government considers to be in the country’s best interests, such as working, saving for retirement or going to college.
It’s possible that after you’ve claimed one or more tax credits, they’ll add up to more than you owe the IRS in income taxes for that year. If a credit is refundable – and there are only a few of these – it will eliminate your tax bill and the IRS will send you a refund for the difference.
For example, you might owe $1,000 and you qualify for and claim a $2,000 tax credit. Now you owe nothing to the IRS because the credit erases your tax debt, plus you have $1,000 that you didn’t have before, just for spending money on something or doing something the government wants you to do.
Unfortunately, the IRS gets its own tax break if that $2,000 credit is nonrefundable. It doesn’t have to pay you the $1,000 difference. It gets to keep whatever portion of a nonrefundable credit that’s left over.
The Earned Income Tax Credit
Refundable credits are obviously the best, and the Earned Income Tax Credit is the best of them all – if you qualify. First, you must have earned income. After all, the idea behind the EITC is to encourage Americans to work. Self-employment income counts, but you can’t earn too much because this tax credit is specifically geared toward taxpayers who earn the least.
The amount of the tax credit is calculated according to a somewhat complicated formula so it rewards those with the least income and the most children. You don’t absolutely have to have a qualifying child dependent, but you’ll get more of a tax credit if you do.
The maximum credit is worth $6,728 in 2021 if you have three or more qualifying children, but just $1,502 if you don’t have any children. This tax credit is indexed for inflation so it can be expected to increase a little year by year. And yes, the IRS will remit to you the difference if it works out to more than the tax you owe.
These are the basic rules for qualifying: You must be at least 25 years old, but you can’t yet have reached age 65 if you have no qualifying children. You must have a valid Social Security number, and your spouse must have one, too, if you’re married. And you can’t file a separate married return if you're married. No other taxpayer can be able to claim you as a dependent.
The Child Tax Credit
The child tax credit is partially refundable. It’s normally worth up to $2,000 per child, thanks to 2018 tax reform, which doubled it from $1,000. That's a lot of money, and you could get up to $1,400 back from the IRS after it eliminated any tax debt you might owe.
The IRS ramped up this tax credit considerably in 2021 in response to the coronavirus pandemic, although just for this one tax year only. It increased to $3,000 per child over the age of six, and to $3,600 for children age six and younger. Families began receiving advance payments of this credit in July 2021. They didn't have to wait until April 2022 to file their 2021 returns and claim it.
This is another credit you’ll lose out on if you earn too much, but the Tax Cuts and Jobs Act significantly raised the income limits for not qualifying due to income factors. You’ll be eligible as long as your taxable income is less than $200,000, or $400,000 if you’re married and filing a joint return. And again, you must have some earned income in order to qualify. The increased 2021 credit is subject to lesser incomes, however: $112,500 or $150,000 if you're married and file a joint return. You would receive the standard $2,000 credit if your 2021 income surpassed these thresholds.
Each child for whom you’re claiming the credit must have a valid Social Security number at the time of the due date for your tax return. This is a new wrinkle, also provided for under the Tax Cuts and Jobs Act. Your qualifying child can be no older than age 16 on the last day of the tax year, and must be a U.S. citizen, a U.S. resident alien or a U.S national. The coronavirus adjustments temporarily increased this to age 17, but again for just one year only.
Read More: Child Tax Credit: What It Is and How to Qualify
Education Credits – The American Opportunity Tax Credit
The American Opportunity Tax Credit rewards you for spending money so that you, your spouse or your dependents can go to a post-secondary college, university or vocational school. It, too, is partially refundable. It’s worth up to $2,500 of what you spend per student on qualified tuition, education expenses, fees and course materials.
Students have to be enrolled at least half-time for at least one academic period during the tax year, and the credit is limited to the first four years of college. Graduate students don’t qualify.
Income thresholds come into play with this tax credit as well. If you earn more than $80,000 and you’re single, or more than $160,000 if you’re married and filing a joint return, the credit begins reducing in amount until, eventually, you can’t claim it at all.
The Other Education Credit – The Lifetime Learning Credit
There are actually two education tax credits, but the second one – the Lifetime Learning Credit – isn’t refundable. That might be because it has somewhat more flexible rules. It covers graduate school, and students don't have to be enrolled at least half-time to qualify. They do have to be enrolled for at least one academic period per tax year, however.
This credit begins phasing out at lower income levels: $59,000 for single filers and $118,000 for those who are married and filing jointly as of the 2021 tax year. The credit is eliminated entirely at incomes of $69,000 for single filers and $138,000 for joint married filers in 2021.
The Lifetime Learning Credit works out to $2,000 for the first $10,000 you spend on all qualified education expenses. It's not calculated per student. You can add all your expenses together to qualify for the largest possible credit.
Almost all tax credits are designed to give a financial boost to low-income and moderate-income earners.
The Premium Tax Credit
The term “premium” refers to health insurance premiums. It doesn’t necessarily mean that this tax credit is top-of-the-line-better-than-the-rest. It’s refundable, however, and it’s even refundable in advance of filing your tax return if you ask to have the amount of your refund sent to your health insurance company to defray some of the costs of your monthly premiums.
Of course, there are a couple of catches. You can only buy your insurance through the Health Insurance Marketplace. The IRS must agree that any employer-sponsored insurance you have access to is unaffordable for you, and you can’t be eligible for insurance through the government, such as with Medicare.
There are income limits here as well, and you generally can’t claim the credit if you’re married and filing a separate return, although there are exceptions to this rule for abandoned spouses and victims of domestic violence.
The Child and Dependent Care Credit
The Child and Dependent Care Credit reimburses you for some of what you must pay for childcare so you can go out to work or to look for work. But it’s not limited to just your children. You’ll also qualify if you have to pay for care for a disabled adult who can’t take care of himself, even if that adult is your spouse and not your dependent.
The whole premise behind this tax credit is that your child, spouse or dependent is incapable of self-care while you’re out earning a living. The IRS figures that a teenager is perfectly capable of self-care – although some parents might disagree – so this credit is therefore limited to care provided for children who are under age 13 unless they’re disabled.
It normally works out to a percentage of what you spend on care up to $3,000 for one child or $6,000 for two or more children. In other words, if you spend $8,000 on your two children, only $6,000 of that counts toward the tax credit. The base amount – $3,000 or $6,000 – depends on several interlocking factors that can potentially reduce it, including your income. The most this credit can be is 35 percent of your childcare-related expenses.
The IRS improved on this credit as well in response to COVID-19. It increased the care cost limits to $8,000 and $16,000, but again, for tax year 2021 only.
The Adoption Tax Credit
The Adoption Credit is pretty self-explanatory: Adopt a child and the government will help you out at tax time. The maximum amount is pretty significant, too – up to $14,440 in adoption expenses per child in the 2021 tax year, increasing from $14,300 in 2020 – but this can be reduced by a number of factors. You have to have at least this much in adoption expenses to qualify for the full amount, and this credit is also subject to income phaseouts. It begins reducing at incomes of $216,660 in the 2021 tax year, and it’s eliminated entirely at incomes of $256,650 or more.
The Adoption Credit isn't refundable, but you can carry any unused portion forward to future tax years for up to five additional years. The IRS doesn’t necessarily get to “keep” any unused portion of this tax credit unless you don’t ever have any tax liability for it to offset during that six-year period: the first year and an additional five.
The Adoption Credit has a provision for special needs children, allowing you to claim the full amount of the credit, even if you didn’t spend that much on the adoption because the state or county reimbursed you for some or all of your costs. "Special needs" in this context means a determination by the state that the child would not be adoptable if the state didn’t offer adoptive parents some incentive, such as subsidies to cover the cost.
Read More: Adoption Tax Credit: What It Is and How to Qualify
The Saver’s Credit
The Saver’s Credit, also known as the Retirement Savings Contributions Credit, gives low- and moderate-income earners a pat on the back for saving toward retirement. It’s worth a percentage of up to $1,000 in contributions for single taxpayers and $2,000 for married couples filing joint returns, but “up to” are the keywords here. Like some of these other credits, the maximum amount of contributions can be reduced by a number of factors, including your tax filing status.
Contributions to most retirement plans are covered, including IRA and 401(k)s. Income limits for 2021 for this credit are $33.000 for single taxpayers, $49,500 for heads of household, and $66,000 for married taxpayers filing jointly. The credit begins phasing out – you'll receive less than the full credit – at lower thresholds: $19,750 if you're single, $29,625 if you qualify as head of household, and $39,500 for spouses who file joint returns.
You must be at least 18 years old to claim the Saver’s Credit, and you can’t be a full-time student.
The Saver’s Credit is beneficially unique in one way, even though it’s not refundable. You can also take a tax deduction for your retirement contributions, so it’s sort of a double gift from the IRS. First, your contributions reduce your taxable income, then you might get a tax credit, too, to wipe out what you owe to the IRS.
- IRS: Credits and Deductions for Individuals
- TurboTax: The 5 Biggest Tax Credits You Might Qualify For
- TurboTax: What Are Tax Credits?
- USA.gov: Tax Credits and Deductions
- National Resource Center on Domestic Violence: Other Tax Credits for Low Income Individuals and Families
- IRS: The Premium Tax Credit – The Basics
- IRS: Lifetime Learning Credit
- IRS: Topic Number 607 – Adoption Tax Credit and Adoption Assistance Programs
- IRS: Retirement Savings Contributions Credit (Saver's Credit)
- IRS: Topic 602 Child and Dependent Care Credit
- IRS: Earned Income Tax Credit Income Limits and Maximum Credit Amounts
- IRS: IRS Provides Tax Inflation Adjustments for Tax Year 2021
- TurboTax: How to Calculate Your Lifetime Learning Tax Credit on IRS Form 8863
- IRS: 2020 Instructions for Form 8839 Qualified Adoption Expenses
- The White House: The Child Tax Credit
- IRS: American Opportunity Tax Credit
- IRS: Child and Dependent Care Credit FAQs
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.