For the most part, there are two tools to reduce your income tax burden: credits and deductions. Credits count directly against your taxes owed. For example, a $200 credit can reduce your taxes owed by $200. Deductions (as discussed in another post) reduce your income that is subject to tax. For example, a $200 deduction will reduce your taxable income so the benefit is based on your tax bracket: it will reduce your taxes by $20 if your bracket is 10%, $24 if your bracket is 12%, $44, if your bracket is 22%, etc… This does not mean a credit is better than a deduction as there may be other benefits to having a lower income. Also, credits are often based on a percentage of expenses so depending on your tax bracket, you may be better off using the expenses for a deduction instead of a credit.
Credits fall into two categories: nonrefundable and refundable.
A nonrefundable tax credit will only reduce your taxes owed by the amount of the credit. If the value of your credit exceeds your taxes owed, it will not increase your refund by more than the taxes owed. For example, if you owe $752 of income taxes and received a nonrefundable credit of $1,000, then your taxes owed will be reduced to $0; you won’t receive any of the unused $248 back.
Nonrefundable credits only count against income taxes. They will not help pay any of the other taxes, such as self-employment tax.
A refundable tax credit basically counts as though it was a payment towards all your taxes. If the refundable credit exceeds the value of your taxes owed, you will get the portion of the credit that exceeds your taxes as a refund. For example, if you owe $752 in taxes and received a $1,000 refundable credit, then you will get a refund of $248.
The IRS treats refundable tax credits the same as payments and withholding to pay taxes, this means they can be used to pay for other miscellaneous taxes like the self-employment tax.
Some Common Credits
People are probably most familiar with the Earned Income Tax Credit (EIC), Child Tax Credit (CTC), and the Credit for Other Dependents (ODC). None of these credits require any expenses to claim. The EIC is a fully refundable credit that is based on your earned income, your filing status, and the number of Qualifying Children you claim. The EIC uses a slightly different definition for Qualifying Child than my post on Dependents. There is no Support test for a Qualifying Child for EIC, meaning a child who can be claimed for the EIC might not be a dependent.
For most tax years, CTC is a partially refundable tax credit based on your earned income and the number of Qualifying Children you claim. The CTC uses a slightly different Age test than the normal rules for Qualifying Child; a Qualifying Child for CTC must be UNDER age 17 by the end of the tax year to qualify. For tax year 2021, the American Rescue Plan modified the CTC to be fully refundable and Qualifying Children only need to be under age 18 by the end of the tax year. However, these changes only apply to tax year 2021; they are set to expire for tax year 2022 and do not retroactively apply to tax years 2020 or earlier.
The ODC is a nonrefundable tax credit based on the number of dependents you have claimed who do not qualify for the CTC.
If you have questions on your tax situation, please send an email to firstname.lastname@example.org and an appointment can be scheduled to discuss the details. As always with any post like this, this is not intended to serve as legal advice and everyone’s situation is different. Please consult an attorney about your situation.