What is a Tax Credit?

While a tax deduction reduces taxable income, a tax credit reduces your tax liability dollar for dollar.

For example, if your adjusted gross income (AGI) was $50,000 and you had $10,000 in deductions, your taxable income would be $40,000 ($50,000 minus $10,000). If your tax rate is 15%, your tax liability is $6,000 (15% x $40,000).

At a 15% tax rate your tax deduction is worth $1,500 in tax savings (15% x $10,000). In other words, each $100 in deductions saved you $15 ($10,000/100 x $15 = $1,500).

However, if you qualified for a $2,000 tax credit your tax liability would be reduced from $6,000 to $4,000, a dollar for dollar reduction in taxes. At a 15% tax rate you would need $13,333 in deductions to slash your tax liability $2,000 ($13,333 x 15% = $2,000 - rounded up).

Types of Tax Crredits

There are two types of tax credits:

  • Nonrefundable
  • Refundable

Nonrefundable Tax Credits:

A non refundable tax credit reduces your tax liability dollar for dollar up to the amount of the tax liability.. For example, a $2,000 nonrefundable credit will reduce a $1,500 tax liability by $1,500, zeroing it out. The $2,000 credit was limited $1,500, the amount of the tax liability.

Refundable Tax Credits:

To provide tax relief to lower income tax payers, tax law allows certain tax credits to be refundable. The Earned Income Credit is an example of a refundable credit.

Refundable tax credits are not limited to the amount of the tax liability. This means, if a qualified taxpayer's tax liability is $2,000 and the refundable credit is $2,500, not only is the $2,000 tax eliminated, the excess amount of the credit, $500, is refunded to the taxpayer as well. This is how the earned income credit works.

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