What is a Tax Credit?

What is a tax credit and how do they work?

A tax return is the document you send to the government every year, documenting how much you earned, how much you paid, what your deductions/exemptions are, etc.

A tax refund is the money the government sends you, if your tax return shows that you paid more taxes than you owed.

 

What is a tax credit?

A tax credit can be either refundable or non refundable. For example, say you have a $200 credit and you owe $100 of taxes. If the credit is refundable, you will pay $0 taxes and receive a $100 refund. If the credit is non-refundable you would pay $0 but basically lose that other $100. The EITC is a refundable tax credit.

 

Using Tax Credits to Reduce Taxes

There are also tax reductions (exemptions, deductibles, etc. there are many names) which allow you to subtract that amount from your income before you calculate taxes. For example say you give $100 to a charity, this is deductible from your income. So to make it easy if you made $10,000 and your tax rate is 10% instead of paying $1,000 you would pay $990 (because your income is considered to be $9,900. Deductions are especially helpful if you are on the border between tax rates.

So in the example above let’s say if you are under $10,000 you pay 5% in taxes. So now instead of paying $1,000 you pay $495. As you can see this amount is much less than the above example (and you’re saving more than your donation you put in) which is why you will see many people make large charitable donations or contribute money to a Roth IRA or various other financial instruments.

 

EITC is a Refundable Tax Credit

More specifically, EITC is a refundable credit; this means that any amount that exceeds your tax liability can be refunded to you (making it possible to get back more than you put in). By comparison, the Child and Dependent Care Credit is non-refundable – it can reduce your liability to zero but can’t generate a refund by itself.