Tax Credits: What They Are & How They Work

What Is a Tax Credit?

A tax credit is an amount that qualifying taxpayers can subtract, dollar for dollar, from their tax bill. While tax credits are often in the same discussion as tax deductions, they are not the same.

Unlike a tax deduction, which reduces your taxable income, a tax credit directly reduces the amount of taxes a person or company owes. The value of a tax credit varies depending on the type of credit.

When considering tax planning strategies, it’s a good idea to examine tax credits that may allow you to reduce the amount of tax you owe.

 

How Do Tax Credits Work?

The federal government may authorize tax credits to encourage behaviors that benefit the environment, the economy or society.

For example, tax credits might be offered to:

• Offset the costs of having children.
• Encourage the adoption of electric vehicles.
• Assist with education-related expenses.

When a taxpayer qualifies for a tax credit, they must claim it when they file their tax return. If you’re filing a paper return, you’ll need to complete a separate form, depending on which tax credits you are claiming. If you’re filing online, you can simply answer the questions regarding tax credits in your tax filing software to claim the credits.

Make sure you have the necessary documentation to prove that you qualify for any credits you claim. While you don’t have to submit receipts or other documentation to claim the credit, you must provide proof if you get audited or questioned by the IRS.

 

Do Tax Credits Give You Money Back?

As mentioned above, tax credits offset the amount of taxes you owe. If your tax credits exceed the amount that you owe for that year, you will receive a money back as a tax refund.

However, keep in mind that not every credit qualifies as refundable. Generally speaking, tax credits are broken into three categories: refundable, partially refundable and non-refundable.

Refundable Tax Credits

Refundable tax credits are paid out in full, even if the credit amount exceeds the tax owed. If the refundable tax credit reduces the amount of tax owed to less than $0, you will receive the remaining amount as a refund. Some of the most common refundable tax credits are the earned income Tax Credit, which benefits low- to moderate-income earners, and the premium Tax Credit, which helps cover the cost of premiums for health insurance purchased through the health insurance marketplace.

Partially Refundable Tax Credits

As the name suggests, partially refundable tax credits are refundable up to a certain amount. For example, the American opportunity tax credit, which covers qualified higher education expenses, provides a maximum annual credit of $2,500 per eligible student. If the credit reduces the amount of tax owed to zero, up to 40% the remaining credit (up to $1,000) can be refunded.

Non-Refundable Tax Credits

Non-refundable tax credits reduce the amount of taxes a person or company owes, but they do not result in a refund. So, if the credit exceeds the amount owed, the taxpayer does not receive the rest of the credit as a refund.

 

Common Tax Credits

There are many tax credits available for qualifying U.S. taxpayers, and the list may change as IRS updates tax regulations each year.

Here are many of the most frequently used credits.

Earned Income Tax Credit

The earned income tax credit is available to low- to moderate-income workers and their families. The credit amount ranges from $649 to $8,046 in 2025, depending on your tax bracket and the number of qualifying children. To claim the EITC, qualifying taxpayers must file Form 8862 with their tax returns.

Health Insurance Tax Credit

The health insurance tax credit, known as the premium tax credit, reimburses qualifying taxpayers for a percentage of the premiums they pay for health insurance through the marketplace. To obtain this credit, you have to meet the requirements and file Form 8962 with your tax return.

Child Tax Credit

The child tax credit provides a tax break for families raising children. In 2024, the credit is worth $2,000 per qualifying child under the age of 17. To claim the credit, you must list the qualifying child or children on your Form 1040 and complete Schedule 8812. This credit is slated to go back to $1,000 for tax year 2025.

Work Opportunity Tax Credit

This tax credit applies to businesses rather than for individuals. The work opportunity tax credit offers a tax incentive for employers who hire workers from underrepresented groups in the workforce, such as veterans, ex-felons and summer youth employees.

Child and Dependent Care Tax Credit

Taxpayers who pay for the care of a child or other dependent so they can work or look for work may qualify for the child and dependent care tax credit. Qualifying taxpayers can claim up to $3,000 for one dependent or $6,000 for two or dependents by filing Form 2441.

Adoption Tax Credit

For tax year 2024, the adoption tax credit provides a credit of up to $16,810 for the expenses related to adopting a qualifying child. Adoption expenses that were reimbursed by an employer cannot be claimed for this tax credit. If you qualify, complete Form 8839 and file it with your tax return.

For 2025, the adoption tax credit increases to $17,280.

Retirement Savings Contribution Credit

Also known as the saver’s credit, the retirement savings contribution credit applies to eligible contributions made to an IRA or employer-sponsored retirement plan. To claim this credit, you must be 18 or older, not claimed as a dependent on anyone else’s tax return and not a full-time student. Qualifying taxpayers can claim 50%, 20%, or 10% of their eligible contributions depending on their tax bracket.

Lifetime Learning Tax Credit

The lifetime learning tax credit is a non-refundable tax credit for those who pay for qualified higher education expenses but may not qualify for the American opportunity tax credit. Qualifying taxpayers can claim up to $2,000 per qualifying student. To claim this credit, you must have received a 1098-T from the higher education institution.

Residential Energy Tax Credits

If you are a homeowner and make energy-efficient updates to your home, you may qualify for the energy efficient home improvement tax credit or residential clean energy credit. For example, replacing windows, exterior doors, water heaters, fuel cells or other upgrades with qualifying energy-efficient alternatives, you are eligible to claim a credit up to 30% of the cost of the upgrades.

Electric Vehicle Tax Credits

If you purchase a qualifying electric vehicle, you may qualify for a clean vehicle tax credit of up to $7,500. To claim this credit, you must complete Form 8936.

 

Credits vs Deductions

Both tax credits and tax deductions can reduce your tax liability, but they work differently. A credit reduces the actual amount of tax you owe, while a deduction reduces your taxable income.

Here are examples to better understand the difference between credits and deductions:

• If you earn $100,000 and have $20,000 in deductions, your taxable income is $80,000. If your tax bracket is 20%, you would owe $16,000 in taxes.
• If you also qualify for $6,000 in tax credits, that amount would be subtracted from the $16,000 you owe, reducing your final tax bill to $10,000.

 

Are Tax Credits Good or Bad?

Tax credits reduce the amount of income tax you owe, allowing you to keep more of your hard-earned money. For most people, this is a good thing. Tax credits also benefit the federal government by promoting activities that strengthen the economy, environment and society.

If you have questions about what tax credits are available to you, work with a tax advisor in addition to wealth planners to explore your options.