Tax Credits: What Are They and How Do You Qualify?

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 check 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 ​$6,660in 2020 if you have three or more qualifying children, but just ​$538​ if you don’t have any children. The maximum credit increases to ​$6,728​ in 2021 because this tax credit is indexed for inflation. 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 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 can get ​up to $1,400​ back from the IRS after it eliminates any tax debt you might owe.

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.

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.

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 2020 tax year. The credit is eliminated entirely at incomes of ​$69,000​ for single filers and ​$138,000​ for joint married filers in 2020.

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.

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 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 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 ​$215,520​ in the 2020 tax year, and it’s eliminated entirely at incomes of ​$254,5200​ 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.

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 key words 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 2020 for this credit are ​$32,500​ for single taxpayers, ​$48,750​ for heads of household, and ​$65,000​ for married taxpayers filing jointly. The credit begins phasing out at these thresholds. 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.