Tax Credits: What They Are and How They Work

When tax season rolls around, investors face the possibility of owing taxes, as well as finding ways to reduce their tax bill.

One way to do this is through tax credits. But what are tax credits, and how do they work?

First, let's clear up any confusion between tax credits and tax deductions because there's an important difference. Tax deductions reduce the amount of taxable income, depending on a taxpayer's marginal tax rate, which rises with their level of taxable income. Also, any filer who takes the standard deduction isn't allowed to take advantage of itemized deductions. But that's not the case with tax credits.

At the most basic level, tax credits can decrease what you owe after all other deductions are considered. A tax credit reduces the amount of tax owed, dollar for dollar, and your tax rate has no impact on a credit.

For individuals, tax credits fall into five general categories: family and dependents, income and savings, homeownership, health care, and education. And according to the Internal Revenue Service (IRS), there are two types of tax credits: nonrefundable and refundable.

A nonrefundable tax credit means you get a refund only up to the amount you owe. This tax credit cannot reduce your tax liability below zero.

For example, if you have a tax credit of $500, but you owe $300, you can only claim the $300. (You don't get $200 back.) Also, you can't use nonrefundable tax credits to offset self-employment tax or taxes on withdrawals from individual retirement accounts and other qualified retirement plans. Most tax credits fall into this category.

There are several nonrefundable tax credits available to filers. Some common ones include:

• Foreign tax credit
• Child and dependent care credit
• Education tax credit
• Retirement savings credit
• Child tax credit
• Energy savings tax credit

According to the IRS, if you file for a tax credit, you often need to include separate or additional forms or schedules to prove you qualify.

A refundable tax credit means you get a refund if the credit is greater than the amount you owe in taxes. So, this time, if you owe $300 and the refundable tax credit is $500, Uncle Sam will send you a refund for the remaining $200.

One refundable tax credit related to investing is a credit for tax on undistributed capital gains. Holders of mutual funds or real estate investment trusts who paid tax on capital gains distributions may be eligible for this credit. Other well-known refundable tax credits include the earned income credit and the American opportunity tax credit for higher education.

Refundable tax credits are classified as payments. So, unlike nonrefundable tax credits, refundable credits can help offset your self-employment tax and qualified retirement plan distribution tax.

It's worth working with your tax preparer to see which tax credits might apply to you. Even if you weren't eligible for tax credits in past years, the many ongoing changes to the tax code may change your eligibility status.

Qualifying for credits may not make preparing your taxes more fun, but at least they could help take the sting out of paying Uncle Sam.