Remember that time you dug out the old jacket you hadn’t used in months from the closet and found a $20 bill hiding inside one of the pockets? Makes you want to do a happy dance just thinking about it, right?
In the tax world, finding out if you qualify for a tax credit can feel a lot like finding that unexpected $20 bill—only much more valuable! Tax credits can magically shave hundreds, or even thousands, of dollars off your tax bill. Now that is worth busting a move or two!
Let’s take a closer look at what tax credits are, how they work, and which ones you might be able to claim on your tax return this spring.
What Is a Tax Credit?
A tax credit reduces how much you pay in taxes by letting you subtract a certain amount of money directly from your tax bill. A $500 tax credit, for example, will save you $500 in taxes owed. The more tax credits you claim, the more money you get to keep in your pocket!
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What’s the point of having tax credits? The government sometimes uses taxes to try to discourage folks from certain behaviors or activities (think taxes on cigarettes). But Uncle Sam will also dangle a tax credit like a carrot on a string to encourage certain behaviors and activities that might be beneficial for the economy, the environment or some other cause.
Tax credits are also a way to provide a tax break for low- and middle-income taxpayers who need it most.
What’s the Difference Between a Tax Deduction and a Tax Credit?
While tax deductions and tax credits both lower how much you’ll pay in taxes, they do it in different ways. Deductions lower your taxable income while tax credits lower how much you actually owe in taxes dollar for dollar.
How does all that work? Well, if you’re in the 22% tax bracket, a $1,000 tax deduction will cut $220 off your tax bill. That’s pretty good! But a $1,000 tax credit will actually save you $1,000 in taxes for the year.
Here’s what that looks like: Let’s say your income is $42,000 per year, putting you in the 22% tax bracket. To figure out what you’d owe in taxes without any credits or deductions, start by multiplying your income by 22%--in real life, not all your money’s taxed at 22% because of how tax brackets and tax rates work, so your dollar amount would be lower than what we have below (thankfully!), but for the sake of this example, we’re keeping it super simple.
$42,000 x .22 (same thing as 22%) = $9,240
That means that without any credits or deductions, $9,240 is the amount you’ll shell out for income taxes.
Now, if you get a $1000 tax deduction, that means your taxable income drops down to $41,000. So let’s do that same calculation again (with your new taxable income to figure out your savings with a deduction.
$41,000 x .22= $9,020
Voila! With a $1,000 tax deduction, your owed taxes fell from $9,240 to $9,020, giving you $220 in tax savings!
Now using the same example with your income of $42,000, imagine you qualify for $1000 in tax credits. That means $1000 is taken off of the $9,240 total you owed in income taxes, making your new total $8,240.
$9,240 - $1000 = $8,240
So, between deductions and credits, it’s pretty clear to see that tax credits are the more valuable of the two. Every dollar counts!
Refundable vs. Nonrefundable Tax Credits: How Do Tax Credits Work?
While tax credits are great, not all tax credits are created equal. That’s because a tax credit can either be refundable or nonrefundable.
You still subtract both types of tax credits from what you owe in taxes, but there’s a big difference if the credit is greater than the amount you owe. With a refundable tax credit, the difference is paid to you as a refund! But with a nonrefundable credit, you won’t get a refund—the best you could hope for is to reduce your tax bill to zero.
For example, let’s say you owe $500 in taxes this year. If you’re eligible for a $750 nonrefundable tax credit, your tax bill goes down to zero, which is great, but you wouldn’t receive the extra $250 as a refund. Uncle Sam says, “we’re even,” and the amount that’s left over is basically lost.
But what if that $750 tax credit was a refundable tax credit? In that case, the credit would cover your whole $500 tax bill and the remaining $250 would come back to you as a check from the IRS. Nice.
Unfortunately, most tax credits are nonrefundable (boo!), but there are still some refundable tax credits you might qualify for.
What Tax Credits Are Available for Taxpayers?
There are dozens of tax credits available for all kinds of taxpayers, from parents and low-income workers to students and Americans living overseas. Chances are there’s one or two you might be able to claim on your tax return.
Here’s a rundown on some of the most common tax credits you might be able to claim this year.
Earned Income Tax Credit
This is the Big Kahuna of tax credits! The EITC is a refundable credit designed to help out low- and middle-income workers. In the past, it’s been geared toward families with children, but recent legislation has made it more beneficial for childless workers as well. Depending on your income, your filing status and how many children you have, the credit could save you a few hundred to several thousand dollars on taxes!
A single, childless worker earning up to $15,980 during the 2021 tax year might be eligible for the EITC. That number jumps up to $57,414 for a married couple with three children.1 And while this is the most popular credit out there, the IRS estimates that one out of five taxpayers who are eligible either don’t claim the benefit on their taxes or don’t file a tax return at all.2 Don’t make that mistake! Every dollar counts. Have we mentioned that?
Child Tax Credit
Kids are awesome. Kids are also expensive. The 2018 tax reform bill gave families a break with the Child Tax Credit (CTC). Cool. But the March 2021 passing of the American Rescue Plan has made the CTC even more substantial. For 2021 taxes, the CTC is a total of $3,600 each for kids ages 0–5 and a total of $3,000 each for kids ages 6-17.3
Write this down, because it’ll be on the test: You won’t just subtract those gigantic tax credits from your total tax bill next spring. Instead, the government will send it to you in chunks. The first half of your credit—half meaning $1,800 for each small child and $1,500 for each older child— will be issued to you in “periodic” payments over the course of July to December 2021. “Periodic” might be monthly payments, but the government’s asking for a little grace while they’re getting that situated. Then, you’ll claim the second half of the credit on your taxes when you file next spring.
Lastly, the CTC is a fully refundable credit. If it’s worth more than what you owe in taxes, your family can receive any leftover credit as a refund.4 Thanks, Junior!
There are two major tax credits available for students. First, there’s the American Opportunity Credit. This credit is available only for students in their first four years of college and it’s worth up to $2,500 per student. Plus, it’s partially refundable, meaning you can receive up to $1,000 as a tax refund—even if you don’t owe anything in taxes.5
If you’ve been in school longer than four years or you’re taking courses to advance your career, then the Lifetime Learning Credit is for you. Although this credit is nonrefundable, it can still cut your tax bill by up to $2,000.6 So stay in school, kids!
Retirement Savings Contributions Credit (Saver’s Credit)
This one’s for all you retirement savers out there! Also known as the Saver’s Credit, this nonrefundable credit helps low- and middle-income taxpayers who are saving for retirement. Depending on how much you make and what your tax filing status is, you can claim the credit for 50%, 20% or 10% of the first $2,000 you contribute to your retirement accounts, including 401(k)s and IRAs.
If you’re married filing jointly, your adjusted gross income has to be less than $66,000 in order to qualify for this credit (for singles, it’s $33,000 or less).7
Foreign Tax Credit
Just because you’re an American living overseas doesn’t mean you’re free from Uncle Sam’s grasp. But cheer up! To ease the pain of being taxed in two or more countries, the income taxes you’ve paid in another country can usually be claimed as a nonrefundable credit to lower your tax burden.8
Child and Dependent Care Credit
If you need to pay for childcare so that you can go to work or if you’re caring for a spouse or parent who is unable to care for themselves, you can get a bigger tax break for 2021. For 2021 taxes, you can claim 50% of up to $8,000 of those costs—think babysitters, day cares and in-home caregivers. For two or more dependents, you can claim 50% of up to $16,000.9 Ask a parent of twins: The cost gets real.
Here’s what that might look like in action:
You pay $275 a week for Mikey to go to All God’s Gazelles day care. That adds up to about $13,000 a year (ouch). You can claim 50% of $8,000 of that as a Child Care Credit. So that’s $4,000 you’ll get taken off your tax bill. Cha-ching!
Elderly or Disabled Credit
Sometimes it pays to be a senior citizen. You get all kinds of discounts, free memberships and some pretty swell tax breaks! If you’re at least 65 years old or you’re retired with a permanent disability, you could knock $3,750–7,500 off your tax bill with this nonrefundable tax credit.10
Get Your Taxes Done Right
Think you might qualify for one of these tax credits, but you’re just not sure? You’re not alone. Unfortunately, millions of dollars in tax credits go unclaimed each year—that’s money that should be in your bank account instead of the government’s coffers!
That’s where Ramsey SmartTax—the tax software designed with you in mind—comes in clutch. Not only will Ramsey SmartTax help you figure out the amount you owe and file your taxes, but you’ll also be able to determine your deductions and tally up your credits. That way all the money that belongs with you stays safe and sound in your pocket.
But hey, if your situation is a little too complicated to handle on your own, our tax Endorsed Local Providers (ELPs) are here to serve you. These tax advisors will take the time to get to know you and your tax situation so that you don’t miss out on any tax credits you qualify for.