What Are Tax Credits and How Do They Work?

If you want to minimize the amount of taxes you’ll owe the government, paying attention to tax credits and tax incentives are critical. But, figuring out your taxes can be a complicated and tedious process.

After all, what are tax credits, and how do you know which ones you qualify for?

To help you through the process, here is everything you need to know.

What Are Tax Credits?

Tax credits are “dollar” credits that deduct the amount you owe to the IRS. If you own $2,000 in taxes but have $400 in tax credit, you would only owe $1,600 in taxes.

The more tax credits you have, the fewer taxes you will owe.

Tax credits are a means for the government to pass extra cash to people with kids, disabilities, or low to middle incomes. They are often directly correlated with income, children, and age.

Recently, there’s also been an uptake in tax credits for environmentally friendly purchases. For example, there are tax credits for solar electric and solar heating systems as well as energy-efficient cars and solar panels.

Tax Deduction vs. Tax Credit

Tax deductions and tax credits are related, but they aren’t synonymous. Tax deductions reduce your taxable income. They don’t reduce the taxes you owe at the dollar-to-dollar ratio but rather by lowering your income tax.

Both tax credits and tax deductions save you money; they just do it in different ways.

What Tax Credits Are Available to Taxpayers

There are several different types of tax credits that you should be aware of when you’re doing tax preparation.

One of the most common tax credits is the Earned Income Tax Credit (EITC). Unfortunately, many taxpayers don’t realize they qualify for this tax credit and miss out on significant savings.

The EITC is a refundable credit that helps those with children who earn a lower income. Depending on the number of children and income, it can save taxpayers thousands of dollars.

Another tax credit to be aware of is the child tax credit, which was recently passed in March 2021. This is a refundable tax credit that helps cushion the cost of children. It can potentially save families thousands of dollars.

You should also be aware of the foreign tax credit if you’re living abroad. The income taxes you’ve paid in another country can be claimed as a nonrefundable credit.

There’s also an adoption tax credit to help cover adoption fees and child expenses and elderly tax credits for those above the age of 65.

Now You Know How to Take Advantage of Tax Credits

So, what are tax credits? Now you know!

Whenever possible, you should always take advantage of them. Tax credits can save you a ton of money and cushion the cost of major investments and family expenses.

Be sure to research the tax credits available in your state to know which to apply for during tax season. You may be shocked by the massive savings it could bring you!

And for more helpful financial information, be sure to check out the rest of our blog. We have a ton of other great articles to help you through your tax process!