How is a tax credit different from a tax deduction?

Tax deductions reduce your taxable income, or the amount of income that is subject to tax. Tax credits, however, reduce the amount of tax you owe. So credits actually save you more money than deductions.

Say your taxable income is $60,000. If you have a deduction worth $10,000, your taxable income is reduced to $50,000. If you’d been taxed on that $10,000 at your normal tax rate, say 20 percent, then the deduction saves you $2,000. But if it you had a tax credit of $10,000 instead of a deduction, your tax savings would be $10,000 rather than $2,000.

Tax deductions are applied before figuring your tax bill, as they affect your taxable income. Tax credits are applied after figuring your tax bill and they reduce it directly. So if you owe $2,000 in income taxes and you qualify for a $2,000 tax credit, your tax bill goes to zero. 

What if your tax credits take your tax bill below zero?

Yes, it’s possible to have tax credits that equal more than your taxable income. In that case, it’s rare to get paid back for that deficit—but it does happen. 

Most tax credits are non-refundable, meaning they allow you to reduce your taxes but they don’t allow the government to pay you back for an overage. However, there are a few tax credits that are refundable.

For example, the Earned Income Tax Credit (EITC) reduces tax liability for working people with low to moderate income and can provide a refund. (And if you earn less than about $55,000, you may qualify.) For people who qualify, the amount of this credit ranges from $529 to $6,557 in 2019, depending on a person’s filing status and how many children they have. So if you owe $4,000 in taxes and you qualify for the full EITC, you’d get a refund of $2,557. 

Which credits might help reduce my taxes?

Aside from the EITC, there are a number of other tax credits you may be qualified to take. The credits taxpayers take most often focus on raising children, saving for retirement, investing in education, and going green. 

Raising a family

If you have kids, you probably qualify for the Child Tax Credit. It used to be nonrefundable but starting in tax year 2018, it became partially refundable. If you meet certain qualifications, you can take a credit of up to $2,000 for each eligible child. And if your credits equal more than your total tax liability, you can get a refund of up to $1,400 for each qualifying child.

Additionally, if you adopt a child (or more than one), you may qualify for the adoption credit, which helps offset the costs of adopting children. The credit is nonrefundable (limited to your tax liability for the year) but any credit in excess of your tax liability can be carried forward for up to five years. The maximum amount for 2018 was $13,810 per child.

Saving for retirement

If you’re socking away money for retirement, you may qualify for the saver’s credit. This credit can be worth up to 50 percent of your contribution to your IRA, employer-sponsored retirement plan or ABLE account (which allows people with disabilities to save for their future without affecting their benefits). You may qualify if you and your spouse earn $64,000 or less, or if you earn $32,000 or less as an individual.

Investing in education

If you or your dependent is attending college at least half time, you may be able to claim the American Opportunity Tax Credit. This allows you a credit of up to $2,500 of qualified education expenses during the student’s first four years of college. To qualify, your adjusted gross income must be no more than $90,000 for individuals or $180,000 for joint filers. This credit is refundable up to 40 percent.

For students who are enrolled in college less than half time, the Lifetime Learning Credit may save you on taxes. It allows a credit of up to 20 percent of the first $10,000 paid toward college expenses, or up to $2,000. To qualify, the student must be you, your spouse or a dependent, and your income can’t be $67,000 or more (or $134,000 if you file a joint return). 

Going green

Because the government wants to encourage more citizens to conserve energy and make more environmentally friendly choices, it offers tax credits when you purchase energy-saving appliances for your home or electric vehicles. The residential energy tax credit allows you a credit of up to 30 percent of the cost of solar energy systems such as solar panels and solar water heaters.

If you purchase a plug-in electric-drive motor vehicle, you could get a minimum tax credit of $2,500 and a maximum credit of $7,500. The amount you get increases based on the car’s battery capacity. But the car must be new: There’s no tax credit for purchasing a used electric vehicle.

What about state income taxes?

If your state charges income tax, it may also offer tax credits to help you reduce the amount of tax you owe. For example, some states offer a tax credit if you make contributions to an account in the state-run college savings fund or 529 plan, a tax-advantaged savings plan to encourage saving for future education costs. Some states offer a renter’s credit, allowing you to reduce your tax liability if you rent housing and meet other qualifications. And some states offer a credit that is similar to the federal EITC for low- and moderate-income earners.

Everybody has a responsibility to pay taxes. But if you qualify for credits that can reduce your tax bill, don’t neglect the opportunity to save money and keep more of your earnings for yourself. 

Investing involves risk including loss of principal. This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Acorns does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns.