What Are Tax Credits & How Do They Work?

Most of us know that tax credits can save taxpayers money, but how exactly do tax credits work? How do tax credits differ from tax deductions? And how do you maximize tax credits to increase your overall tax refund?

Well, not all tax credits can increase your refund. That’s where refundable and nonrefundable tax credits come in. Don’t worry, we’ll get there. We’ll explain all of the ins and outs of tax credits so you can know exactly what to expect this tax season.

What Is A Tax Credit?

A tax credit is an amount of money taxpayers can claim to decrease the amount owed on taxes. Tax credits affect the total a taxpayer or business owes at the end of their tax calculations by reducing the amount of money owed, or even in some cases, increasing the amount received in a tax refund.

Examples Of Individual Tax Credits

For individuals, the most common tax credits are the child tax credit — which gives a nonrefundable tax credit to eligible parents or caregivers — and the earned income tax credit, a refundable tax credit benefiting low-income taxpayers.

Examples Of Business Tax Credits

For businesses, there are many tax credits available. Most business tax credits revolve around renewable or clean energy, investing in low-income communities, hiring minorities, and providing employee benefits.

See a full list of the top business tax credits to see which your business qualifies for.

How Do Tax Credits Work?

Tax credits are amounts of money allotted to taxpayers to decrease the amount of money owed to the IRS during a tax year.

The way tax credits work depends significantly on the individual credit. Some tax credits are nonrefundable and simply lower the amount of taxes you owe. Others are refundable and can increase the amount sent on your tax refund check. Others still are partially refundable and include credit caps and percentage reductions.

So while it’s easy to understand how tax credits work on a basic level, understanding whether you qualify for the credit and then calculating the credit is not always as simple.

The IRS is the best source on each tax credit, how it works, and how much you can get per credit, but accountants and certified tax preparers can be great help with this as well.

Federal Tax Credits VS State Tax Credits

Tax credits can come from the federal level and the state level. Federal tax credits include child and dependent care credits, IRA contributions, education tax credits, and a handful of tax credits just for businesses. Depending on the state you’re in, you may be eligible for additional tax credits like income tax credit or even renter’s tax credit.

Is A Tax Credit A Refund?

Tax credits can sometimes result in a tax refund depending on the type of credit and how much you owe in taxes, but not all tax credits are refunds. Some tax credits are nonrefundable or only partially refundable.

Confusing, I know. We’ll dive into the differences between refundable and nonrefundable taxes to help clear things up.

Refundable Tax Credits VS Nonrefundable Tax Credits

Tax credits fall into two camps: refundable and nonrefundable. Refundable credits mean that if you qualify for the credit and your tax payment is less than the credit, you get a refund for the difference.

Because tax credits reduce the amount of tax you owe dollar-for-dollar, not every tax credit is refundable, meaning not all tax credits increase your refund. All eligible tax credits decrease your tax bill, but not all result in extra cash in your pocket.

• Refundable Tax Credits: A tax credit that can be returned to the business owner as a refund if their tax bill is less than the total credit
• Nonrefundable Tax Credits: A tax credit that cannot be returned to the business owner even if their tax bill is less than the total credit

Certain tax credits can also be “partially refundable.” Usually, the IRS provides a percentage that can be returned if certain criteria are met for these types of tax credits.

What’s The Difference Between A Tax Credit & Tax Deduction?

While both tax credits and deductions can reduce the amount you owe in taxes, the way these tax allowances work is very different.

Tax deductions reduce your overall taxable income, whereas tax credits reduce the tax bill you owe or increase your tax refund.

For example, say Sarah made $100,000. Based on the 2023 tax bracket, Sarah would be taxed at 24%. If Sarah qualified for $20,000 of tax deductions, her overall taxable income would be $80,000, so she would be taxed at 22%, which would save her quite a bit of her hard-earned money.

If Sarah owed the IRS $5,000 after her deductions were taken out and qualified for $2,000 of tax credits, then she would only have to pay the IRS $3,000 instead of $5,000.

While tax deductions and tax credits have fundamentally different applications, they both can be great ways to save money on your taxes. Even better, you can combine the tax deductions and credits you qualify for to get the best of both worlds.

Learn more about how tax deductions work or check out the most common business tax deductions for examples on how to lower your business’s taxable income.

How To Claim Tax Credits

To claim a tax credit, you’ll need to ensure that you meet all of the eligibility requirements. An accountant or certified tax preparer can help you identify which tax credits you’re eligible for.

Once you’ve determined you’re eligible for a tax credit, you’ll likely have to fill out a specific IRS form to calculate and claim the credit. While the process can seem daunting, the payoff is more than worth it and can save you a pretty penny on your taxes.

For more help on business taxes in particular, check out our free small business tax prep checklist or our complete guide to small business taxes.

FAQs About Tax Credits