What are Tax Credits?

Published by Thomas Herold in Accounting, Economics, Laws & Regulations

'Tax Credits' is explained in detail and with examples in the Accounting edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Tax credits refer to different sums of money which taxpayers may deduct from their total tax bill that they owe the federal, state, or local government. The amount of a given tax credit will naturally depend on the type of credit involved.

Some kinds of credits accrue to businesses or individuals who operate (or live) in particular locales, industry segments, or specific classifications. These credits are different from exemptions and deductions that lower the amount of income the IRS considers to be taxable. Instead, a tax credit will actually decrease the amount of tax which the business or individual owes.

Governments often provide such tax credits to foster certain patterns of behavior and actions. This could be to lower the aggregate cost for certain taxpayers’ housing, or for replacing appliances which are older with newer and more efficiently operating appliances.

Generally speaking, such tax credits prove to be more beneficial than an exemption or deduction since they diminish the amount of taxes the entity or individual must pay on a dollar for dollar basis. These other types of expenses and exemptions do lower the ultimate tax liability. Their limitation is that they only reduce this based on the marginal tax rate of the individual or business. This means that those individuals who are considered to be a member of the 15 percent tax bracket only receive 15 cents in tax savings for each marginal tax dollar deduction. On the other hand, the credit decreases such tax liabilities by a whole dollar.

These credits can be broken down into refundable, partially refundable, or nonrefundable tax credits. Refundable credits prove to be the most helpful form since they are refundable in their entirety. No matter how high (or low) the tax liability or income of particular taxpayers may be they will receive the full dollar credit amount. This is still the case even when such a refundable tax credit decreases the tax liability to under $0. In such a scenario, the taxpayers will receive a negative tax liability, which the IRS calls a refund.

Per the year 2016, the most typical refundable tax credit remains the EITC Earned Income Tax Credit. There are similarly other types of refundable tax credits which taxpayers may claim for health care insurance and coverage, for educational expenses and costs, and for raising children.

Other tax credits may be partially refundable. This means that they can reduce taxable income and also decrease the individuals’ (or businesses’) tax liability. In 2016, a partially refundable form of tax credit proved to be the American Opportunity Tax Credit. When taxpayers manage to lower their liabilities to below zero and still have part of the $2,500 (as of 2016) tax deduction remaining, they may apply 40 percent of what is left as a refundable credit.

The final type of such a credit is the nonrefundable tax credit. These the taxpayers may deduct directly from the liability of taxes all the way to the point where the liability then equals zero. The remaining nonrefundable tax credit can not be deployed to take refunds. These types of credits have a negative effect on lower income taxpayers, since they can not gain the full benefit from the credit amount. Such credits which are nonrefundable will only be valid for the particular reporting year too. They also expire once the return has been filed and can not carry forward to future years. Specific examples of such nonrefundable tax credits for 2016 include raising children, adoptions benefits, realizing foreign income, and paying interest on mortgage.

Free Download (No Signup Required) - The 100 Most Important Financial Terms You Should Know!
This practical financial dictionary helps you understand and comprehend the 100 most important financial terms.

The term 'Tax Credits' is included in the Accounting edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.