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Tax Credits 101- Understanding Tax Credits

Joshua V. Azran, partner/owner of Azran Financial (www.azranfinancial.com), gives the basics of tax credits. Learn these tips to make the most out of your taxes.

  1. Non-refundable- can reduce your tax to $0, but cannot be used to provide a refund
  2. Refundable- refund can be received if credit is greater than tax owed

Let’s start off by defining a tax credit and the very first thing we should do for most people to understand is make a distinction between a deduction and a tax credit.

Deductions are going to be used to arrive at your taxable income. Tax credits are going to be used to reduce the amount of tax due after it’s calculated based upon that taxable income so what we’ll think of as a tax credit is a reduction in the amount of tax after the calculation is performed and very generally, there’s two types of credits. There’s refundable tax credits and there’s non-refundable tax credits.

Let’s start off with the non-refundable tax credits. Non-refundable tax credits are distinct because though they can reduce your tax to zero, they cannot be used to provide a refund. In a very simple example, if a taxpayer owes $10,000 in tax and has a $15,000 non-refundable tax credit, they’ll only get to take advantage of $10,000 of that credit reducing their tax to zero.

However, conversely, if that was a refundable tax credit of $15,000, that taxpayer would be in the circumstances to receive a $5,000 refund after the tax credit not only took care of the $10,000 tax due but also provided this additional amount.

Now, jumping back to non-refundable tax credits, let’s give a couple of examples of some of the ones that you might encounter. One of the first ones is of course adoption expenses. Now, the major ones for most people is child and dependent care expenses. Also, as many people are moving towards hybrid cars and alternative energy vehicles, alternative and hybrid vehicles and other types of opportunities exist there and finally on the same theme, look at energy saving home improvements also as providing non-refundable tax credits.

Finally moving on to the topic of education, we look at things like the American opportunity credit and lifetime learning credit which will provide opportunity as in certain circumstances for taxpayers to receive credits based upon those amounts they incurred paying for education.

As we move on from there, some taxpayers who generate income overseas will pay taxes on that income overseas and as such, we receive a foreign tax credit, a credit against their US taxes for those taxes they had to pay to a foreign country.

Finally, we’ll look at the other side of this which is of course those taxes which are – tax credits which are refundable and these will be things like your earned income tax credit or EITC, your first time home buyer credit, certain things like health care coverage credits and a few other types of refundable credits.

Very generally, many of the credits you’re going to encounter are going to non-refundable tax credits. Of course, we could think of this as having slightly less value than those tax credits which are refundable because the refundable tax credits can actually net your refund after even though you have not paid in any additional tax.

So recapping very quickly, we’re going to look at tax credits being those items which are going to reduce the amount of tax due after the calculation is already performed and we’ll break this up into non-refundable credits which again are not as advantageous and refundable tax credits which of course can both reduce your tax liability to zero and provide your refund on top.

If you have questions about these things or how these might apply to you, you could find answers on the IRS website or seek help from your tax accountant or professional advisor.