What are the types of tax credit? For many taxpayers, tax credits are an important part of their overall financial plan. Understanding the types of available tax credits can help taxpayers optimize their returns and save significant amounts on their annual tax bill. In this article, we’ll explore some of the common types of federal and state tax credits available to taxpayers .
What Are The Types Of Tax Credit?
Nonrefundable tax credits reduce the amount of taxes owed but cannot be refunded if the amount is greater than what is due. Refundable tax credits allow for a full refund if no taxes are owed and partially refundable credits only allow for up to half of the value of the credit to be refunded if no taxes are due.
Nonrefundable Tax Credits
Nonrefundable tax credits are a form of tax relief that can reduce an individual’s tax liability, but the credit cannot be carried over to the next year and any remaining balance is lost. This can be particularly disadvantageous for low-income taxpayers who may not be able to use the full credit amount.
For the 2022 tax year, some examples of nonrefundable tax credits include the Adoption Credit and Lifetime Learning Credit. The Adoption Credit helps offset qualified adoption expenses for eligible taxpayers while the Lifetime Learning Credit assists with tuition and other related expenses for post-secondary education.
Both of these credits are designed to help individuals save money on their taxes but due to their nonrefundable nature, they may not provide as much benefit for those with lower incomes.
Refundable Tax Credits
Refundable tax credits are one of the most beneficial types of credits for taxpayers. This is because they are paid out in full, regardless of a taxpayer’s income or tax liability. For example, if the refundable tax credit reduces the tax liability to below $0, then the taxpayer is due a refund of that specific amount.
One of the most popular refundable tax credits is the Earned Income Tax Credit (EITC). This credit is designed to help low- to moderate-income taxpayers who earn income through an employer or by working as a self-employed individual and meet certain criteria based on income and number of family members.
Another refundable tax credit is the premium tax credit which helps individuals and families cover the cost of premiums for health insurance purchased through the health insurance marketplace.
Partially Refundable Tax Credits
Partially refundable tax credits are an important tool for taxpayers to reduce their overall tax liability. One example of a partially refundable credit is the American Opportunity Tax Credit (AOTC), which is available to postsecondary education students and allows them to claim up to $2,500 in deductions.
If the taxpayer reduces their tax liability to $0 before using the entire portion of the deduction, they may be able to take the remainder as a refundable credit up to 40% of the remaining credit or $1,000.
The Child Tax Credit was also a partially refundable credit prior to 2018, but it became fully refundable as part of the Tax Cuts and Jobs Act (TCJA). This allowed taxpayers with large enough tax liabilities to claim up to $2,000 in credits.
The American Rescue Plan further increased this credit and made it fully refundable for 2020 and 2021 tax years. These changes have helped many taxpayers reduce their overall tax burden and receive more money back from their taxes.
Conclusion
Tax credits are an important part of a financial plan and can help taxpayers reduce their overall tax liability. There are three types of tax credits: nonrefundable, refundable, and partially refundable.
Nonrefundable tax credits reduce the amount of taxes owed but cannot be refunded if the amount is greater than what is due. Refundable tax credits allow for a full refund if no taxes are owed and partially refundable credits only allow for up to half of the value of the credit to be refunded if no taxes are due.
Examples of these credits include the Adoption Credit, Lifetime Learning Credit, Earned Income Tax Credit, Premium Tax Credit, American Opportunity Tax Credit, and Child Tax Credit.
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