What Are Tax Credits?

If you’re on the journey toward becoming debt-free or have successfully pulled yourself out of debt, you sprint the opposite direction when you hear the word credit. It’s a dirty word that brings up thoughts of never-ending payments, double-digit interest rates and FICO scores.

But when it comes to taxes, credit is a good word—a very good word. A tax credit can cut hundreds or even thousands of dollars off your tax bill. Finding out you qualify for a tax credit kind of feels like finding that forgotten $20 bill in your coat pocket—only much more valuable. Cue the dance music!

Unless you were living completely off the grid this past year—and, hey, we wouldn’t blame you—you heard about or even received advance Child Tax Credit payments. Yep, the government sent monthly payments to just about everyone in the country with kids. But that’s just one type of tax credit.

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 cuts your tax bill on a dollar-for-dollar basis. So, if you owe $1,000 in taxes, a $600 credit will slash your bill to $400. Boom! Tax credits are money in the bank. The more credits you claim, the less money you have to fork over to good old Uncle Sam. Many credits are linked to your income, age or filing status.

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What’s the point of tax credits? Well, it’s the government’s way to pass along some extra cash to people with kids, disabilities or low or middle incomes. Uncle Sam will also dangle a tax credit like a carrot on a stick to encourage certain behaviors or activities that might be beneficial for the economy, the environment or some other cause.

What’s the Difference Between a Tax Deduction and a Tax Credit?

Tax deductions are similar to credits, but they don’t directly lower your tax bill. Instead, they reduce your taxable income, and if your taxable income is lower, your tax bill will be lower.

How does all that work? Well, if you’re in the 22% tax bracket, a $1,000 tax deduction will lower your taxable income by $1,000, which will cut your tax bill by $220. That’s pretty good! But a $1,000 tax credit will actually save you $1,000 in taxes.

You don’t have to be a rocket scientist to see that tax credits are awesome!

Let’s look at an example: Say your income is $40,000 per year, putting you in the 12% federal income tax bracket. To figure out what you’d owe in taxes without any credits or deductions, multiply your income by 12%. In real life, not all your money is taxed at 12% because of how tax brackets and tax rates work, but for the sake of this example, we’re keeping it super simple.

$40,000 x .12 (aka 12%) = $4,800

That means without any credits or deductions, you’ll shell out $4,800 for income taxes.

Now, if you get a $1,000 tax deduction, your taxable income drops down to $39,000. So, let’s do that same calculation again with your new taxable income to figure out your savings with a deduction.  

$39,000 x .12 = $4,680

Voila! With a $1,000 tax deduction, your taxes fell from $4,800 to $4,680, giving you $120 in tax savings! And here’s a pro tip: If you ever need to figure out how much a deduction will save you on your tax bill, just multiply your tax rate (based on your tax bracket) times the amount of the deduction.

Now, let’s look at tax credits. Using the example above with a $40,000 income, imagine you qualify for $1,000 in tax credits. That means $1,000 is subtracted from your $4,800 tax bill, making your new total $3,800.

$4,800 - $1000 = $3,800

Have we mentioned tax credits are awesome? Every dollar counts!

Refundable vs. Nonrefundable Tax Credits: How Do Tax Credits Work?

All tax credits are great, but some are really great. What makes a tax credit really great? When it’s refundable.

The IRS classifies tax credits in two ways: refundable or nonrefundable. You can subtract both types of credits from your tax bill. But if a refundable credit is more than your total tax bill, you get the difference back as a refund. Yes, you can get a refund even if your tax bill is zero! So, if you owe $1,000 in taxes and you have a $1,500 refundable credit, the IRS will send you $500!

With a nonrefundable credit, you won’t get a refund. The best you can hope for is to reduce your tax bill to zero, which still ain’t too shabby.

Let’s go back to the example above. If the $1,500 credit is nonrefundable instead of refundable, your tax bill will go down to zero, but you won’t receive the extra $500 as a refund. Uncle Sam says, “We’re even,” and the amount that’s left over is basically lost.

And now the bad news: 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 lower 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 of 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 Earned Income Tax Credit (EITC) is a refundable credit designed to help you out if your income is low to moderate, especially if you have children. Depending on your income, your filing status and how many children you have, the EITC could save you a few hundred dollars or up to more than $6,500!

If you’re single and don’t have children, the EITC gradually increases with your income up to a maximum of $560 when your adjusted gross income hits $7,300. As your income increases above $9,200, the EITC gradually decreases until you reach $16,480, and then you’re no longer eligible for the credit.¹ 

If you’re married with three children, the maximum EITC is $6,935 if you earn between $15,400 and $26,300. After that, the credit gradually decreases until you hit $59,187.² 

The IRS estimates that one out of five taxpayers who are eligible either don’t claim the EITC on their taxes or don’t file a tax return at all.³ Don’t make that mistake! 

Child Tax Credit

Kids are awesome. Kids are also expensive. The Child Tax Credit is a refundable credit that can help with family expenses. Thanks, Junior!

For 2022, The Child Tax Credit will likely be back to $2,000 per child under the age of 17—with an income limit of $400,000 for married couples and $200,000 for individuals.⁴ 

The March 2021 American Rescue Plan temporarily boosted the 2021 Child Tax Credit to $3,600 for each kid ages 0–5 and $3,000 for kids ages 6–17. And in case you missed it, the IRS began sending advance Child Tax Credit payments to taxpayers in July. But since the credit boost was not extended for the 2022 tax year, it drops back down to $2,000 a pop for the 2023 tax filing season. Whomp Whomp.

If you received advance Child Tax Credit payments last year, be on the lookout for a letter from the IRS that lists the total amount of advance payments you received. You’ll need it to file your 2021 taxes and receive the other half of your Child Tax Credit.

Education Credits

Whether you’re new to college or dusting off your backpack after a long hiatus, the government offers two types of tax credits for education costs.

The American Opportunity Tax Credit (AOTC) is available for students in their first four years of college, and it’s worth up to $2,500 per student per year. 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’re a parent and paid for all or a portion of your child’s college tuition, you can take advantage of the AOTC. But parents and children can’t both take the credit, so you’ll have to decide among yourselves who gets to use it.

If you’ve been in school longer than four years or you’re taking graduate courses or professional courses to advance your career, the Lifetime Learning Credit is for you. Although this credit is nonrefundable, it can cut your tax bill by as much as $2,000.⁶ It’s worth 20% of up to $10,000 in educational expenses.

Retirement Savings Contributions Credit (Saver’s Credit)

This one’s for all you retirement savers out there! Also known as the Saver’s Credit, the Retirement Savings Contributions Credit is a nonrefundable credit that helps low- and middle-income taxpayers who are saving for retirement. Depending on how much money you make and your tax filing status, 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 traditional or Roth IRAs.

If you’re married filing jointly in 2022, your adjusted gross income must be less than $41,000 to qualify for the 50% credit (for single filers, it’s $20,500 or less).7 To qualify ­­­for the 20% credit, your adjusted gross income must be between $41,001 and $44,000 for married filing jointly and between $20,501 and $22,000 for single. The 10% credit is available until you reach $68,000 for marrieds and $34,000 for singles. 

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

Like the Child Tax Credit, the Child and Dependent Care Credit will most likely revert back to its pre-2021 (American Rescue Plan) amounts for the 2022 tax filing season. 

So, for 2022 taxes, you’ll most likely be able to claim 20–35% of up to $3,000 of those costs—think babysitters, day cares and in-home caregivers. For two or more dependents, you can claim 30% of up to $6,000.⁹ Ask a parent of twins: The cost gets real.  

You pay $250 a week for Mikey to go to All God’s Gazelles Day Care. That adds up to about $12,000 a year (ouch). Let’s say you can claim 30% of $3,000 of that as a Child Care Credit. So, that’s $900 you’ll get taken off your tax bill. Cha-ching!

Adoption Credit

If you’ve expanded your family through adoption, the IRS offers an Adoption Tax Credit of up to $14,890 per child to cover adoption fees and other expenses you paid.¹⁰ It’s expensive adding another mouth to feed! The Adoption Credit is nonrefundable, but if it reduces your tax bill to zero, you can carry over the leftover portion for up to five years.¹¹ 

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 to $7,500 off your tax bill with this nonrefundable tax credit.¹²

File Your Taxes With Confidence

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 hands! 

That’s where Ramsey SmartTax—the tax software designed with you in mind—comes into play. Not only will Ramsey SmartTax help you file your taxes and figure out the amount you owe, 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.

Check out Ramsey SmartTax today!

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 RamseyTrusted tax advisors will take the time to get to know you and your tax situation so you don’t miss out on any tax credits you qualify for.

Find your tax advisor today!