Tax Credit

Updated on January 4, 2024
Article byNanditha Saravanakumar
Edited byAlfina
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Tax Credit?

Tax credit can be defined as a reduction in the total tax amount someone owes to the Internal Revenue Service (IRS). It can be considered a type of financial incentive provided to the citizens by the government to promote activities largely advantageous to society and the economy.

Tax credits help citizens reduce the tax they owe or get a refund on the amount they pay. The government gives credits only in specific and controlled circumstances as it provides greater benefits to the taxpayers and leads to exploitation. However, one must meet specific eligibility criteria to claim these credits.

Key Takeaways

  • A tax credit is an incentive provided to the taxpayers by the government, effectively reducing the total tax paid. 
  • The credit can be in the form of a rebate or a direct reduction of the amount. There are three types of credits based on this – non-refundable, refundable, and partially refundable credits.
  • Credits are not tax deductions. The former reduces the net tax amount paid, whereas the latter reduces the total taxable amount. 
  • Credits on taxes serve as a push to citizens and help them adopt activities recommended by the government. 

Tax Credit Explained

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Tax Credit (wallstreetmojo.com)

The tax credit has two purposes – firstly, it acts as an impetus to motivate the citizens to take up measures of economic significance and contribute to society. Secondly, it provides support to the people in need. As citizens usually pay huge amounts of taxes, credits seem like an attractive option.

Credits offered for using solar power, electric vehicles, etc., act as a stimulus and encourage more people to adopt the system. In addition, other types like working or the disability tax credit acts as as financial support to deserving citizens.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

The working or the earned income tax credit (EITC) reduces tax for people from the low-middle income range. The disability tax credit relieves persons with disabilities by decreasing their financial obligations. 

Taxpayers can claim their credit while filing tax returns. Then, based on their eligibility and the total value of the credit, they can apply for the reduction, depending on the type of the credit. Also, they can use a tax credit calculator, available online, which uses information like adjusted gross income and credit value to calculate the tax amount owed, credits, etc. Alternatively, they can consult a tax professional for the same.

Here, it is important to note that credits are not the same as deductions. In the former, the credit amount is subtracted from the tax amount payable, whereas in the latter, the amount is deducted from the total taxable income. Hence, the benefits for taxpayers from credits will be more than from deductions. 

For example, if a person’s taxable income is $50,000 and the tax rate is 22%, the total tax amount will equal $11,000. A tax deduction of $1000 will reduce the taxable income to $49,000. It will give a tax amount of $10,780. But the credit of $1000 will reduce the amount owed to $10,000. Thus, the credit provides more gains (here, $780).

One can claim tax deductions as either standardized or itemized. Some popular tax deductions are for the mortgage, charitable donations, medical expenses, etc.

Types of Tax Credit

There are three main types of credits – non-refundable, refundable, and partially refundable. 

  1. Non-Refundable Credits: Such credits are usually given for mortgages, education, etc. The taxpayer can reduce the amount they owe using their credits. However, if the amount reaches $0 and their credit value exceeds the tax amount, they will not get a refund. Such credits are valid only for a year and are not carried over to the next years. For example, if the tax amount of a person equals $1000 and they have a credit of $1200, their amount will be bought to $0. Hence, they will not have to pay the amount, but the balance of $200 of the credit will go unutilized. This amount will not be transferred to the next year either.
  2. Refundable Credits: Eligible taxpayers entitled to tax refunds will get the balance credit amount if any. It benefits the taxpayers, as they can enjoy the full value of the credits. Working Tax Credit is a type of refundable credit. In the above example, the taxpayer gets a reduction of $1000 on the tax they owe and also receives a $200 refund.
  3. Partially Refundable Credits: The taxpayer receives a percentage of the balance credit amount. For example, if the excess credit amount is $200, a person receive a rebate of 40% or so, depending on the type of credit. The American opportunity tax credit is one such example.

Examples

Consider the following examples to get a better idea:

Example #1

Let’s look at the case of country X. The government decides to offer a 25% credit to individuals who have installed solar power systems in their homes. The decision was taken to promote the use of renewable sources of energy. As a result, many consumers adopted solar technology and they received credits for it.

Example #2

Here’s a real-life example of the United States automobile industry racing to beat China and Europe in the electric vehicles (EV) revolution. Automobile giants like General Motors, Ford, and Toyota are requesting the government for a $7500 purchase credit. The credits are important for the country’s goal to achieve 50% EV sales by 2030.

Without the credits, the companies would shift production to China or Europe. According to the Boston Consulting Group (BCG) estimates, the country will achieve 47% of the EV sales with the incentives. Conversely, if the government fails to incentivize, it will only be able to reach 35% of the sales. 

Frequently Asked Questions (FAQs)

Are tax credits refundable?

It depends on the type of credit. Some credits are non-refundable, while others are fully or partially refundable. 

Who is eligible for the earned income tax credit?

The EITC only applies to people in the low and middle-income range. According to the IRS, a person should have earned an income of less than $57,414 and have an investment income below $10,000 (data for the year 2021). 

How much is the disability tax credit?

The credit for the elderly and disabled ranges between $3750 and $7500, depending on the adjusted gross income and other pensions from the government.

How do tax credits work?

Eligible taxpayers can apply for the appropriate amount while filing tax returns. Then, depending on the refundability and total value of the credit, they can bring the tax amount owed to $0 and even get a refund. 

This has been a guide to Tax Credit and its definition. We explain its types, examples, and how tax credit works along with a detailed explanation. You can learn more from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *