What is a tax credit?
A tax credit reduces your tax liability dollar for dollar. For example, if you make $50,000 per year and your tax liability is $6,000, a tax credit of $4,000 means that your tax liability will be reduced to $2,000. In this case, a tax credit of $4,000 generates additional refund of $4,000 to you.
Why is a tax credit better than a tax deduction?
A tax credit, for the most part, is better than a tax deduction because tax deductions only reduce the amount of your taxable income before arriving at your tax liability. In essence, your liability will only be reduced by the amount of the deduction multiplied by your tax rate. For example, if you have a tax deduction of $3,000 and your tax rate is 20%, your liability will be reduced not by $3,000 but only by $600 ($3,000 x 20%). Whereas, when you say a tax credit of $3,000, this means that your liability will be reduced by the full $3,000.
There are three types of tax credits: the refundable, non-refundable, and the unused credits carry forward.
Types of Tax Credit:
1. Non-Refundable Credit is a tax credit that can reduce your tax liability to zero but if the tax credit is more than the tax liability, the excess credits are not refunded to you. For example, if your tax liability is $3,000 and you have a tax credit of $4,000, the amount of credit that you can avail is only $3,000; the other $1,000 will be forfeited and wonâ€™t be refunded to you. This will be considered as â€œwasted tax credit.â€
â€¢ Saver’s Credit
â€¢ Alternative Motor Vehicle credits – hybrid, electric, alternative fuel, fuel cell, etc.
â€¢ Hope Credit
â€¢ Lifetime Learning Credit
â€¢ Dependent Care Credit
â€¢ Child Tax credit
2. Refundable Credit â€“ not only reduces your tax liability to zero but also allows you to receive any excess credit back for that same year. For example, if your tax liability is $3,000 and your tax credit is $4,000, youâ€™ll be able to avail the whole $4,000. The first $3,000 will be used to reduce your tax liability and the excess credit of $1,000 will be your additional refund.
â€¢ Earned Income Credit (EIC)
â€¢ American Opportunity Credit
â€¢ First-time Home Buyers Tax Credit – available only in 2008 to 2010 tax years
â€¢ Additional Child Tax Credit
â€¢ Adoption Credit – Â converted to a refundable credit in 2010
â€¢ Making Work Pay – (Available only in 2009 and 2010 unless extended)
3. Carry Forward credit -This reduces the tax liability down to zero but if the tax credit is more than the tax liability, the excess credit are not forfeited and not refunded in the same tax year. Instead, the credits are carried over and applied to subsequent years until the credit is fully exhausted.