Tax Credits: What They Are and How They Work

March 27, 2024 Hayden Adams Beginner
Tax credits can help reduce your tax burden and let you keep more of your money.

Tax season is underway, which means it’s time to figure out what you owe—and hopefully find some ways to potentially reduce your tax bill. You probably know that one way to reduce your taxes is through tax credits. But what are tax credits exactly, and how do they work?

Tax credits vs. tax deductions

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 you have, which in turn reduces your tax bill. On the other hand, a tax credit decreases your tax bill, dollar for dollar.

Types of tax credits

Nonrefundable tax credits

A nonrefundable tax credit can reduce your taxes to zero, but not below that level. Here’s an example: If the nonrefundable tax credit is for $500, but you only owe $300 in taxes, you can only claim up to $300 of the tax credit. 

Nonrefundable tax credits are the most common credits in the federal tax code, and there are numerous credits available to filers. Here are some of the most common:

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

Refundable tax credits

With refundable tax credits, if the tax credit is greater than the amount of taxes you owe, you could potentially get a refund. Refundable tax credits can be either fully or partially refundable, depending on the type of credit. Using the same example, if you owe $300 in taxes and the $500 tax credit is fully refundable, the credit will whip out the $300 in taxes and the IRS will give you a refund for the remaining $200. 

Here are some common refundable tax credits:

  • Earned Income Tax Credit (EITC) 
  • Child Tax Credit
  • American Opportunity Tax Credit

To learn more about refundable tax credits, check out the IRS website.

It’s worth working with your tax professional to see which tax credits you may qualify for. Even if you weren’t eligible for tax credits in past years, the tax laws are constantly changing, and you may be eligible for a credit this year. Qualifying for credits may not make preparing your taxes any more fun, but at least credits could help take the sting out of paying Uncle Sam.

Schwab does not provide tax advice. Clients should consult with a tax advisor with regard to their specific tax circumstances.

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Schwab does not provide tax advice. Clients should consult with a tax advisor with regard to their specific tax circumstances.