How Tax Credits Work
Reduce Your Tax Bill With Tax Credits
Tax planning involves making use of all the deductions and credits you're entitled to in a given tax year. Deductions come off your income, reducing it so you pay taxes on less earnings. Credits subtract from the tax you owe. That makes credits more advantageous than deductions. Here's how it works.
What Is a Tax Credit?
The Internal Revenue Service offers several tax credits. You can claim credits for foreign taxes, child care expenses, college tuition and fees, and for costs associated with adoption. You might also be eligible for credits based on your age or a disability, if you contributed to a retirement savings account, and if you have minor children who live with you.
A tax credit is a dollar-for-dollar reduction of your gross tax liability, the total amount of taxes you're responsible for paying before any credits are applied. You can find your gross tax liability on line 47 of the 2016 Form 1040, on line 30 of Form 1040A, and on line 10 of Form 1040EZ.
Taxes withheld from your pay during the year are a prepayment against your gross tax liability. You get a refund for any balance in excess of what you actually owe if too much is withheld from your pay.
Refundable vs. Nonrefundable Credits
Tax credits reduce your gross tax liability, but not necessarily below zero. If you qualify for several credits, some of them may be wasted after your tax bill is erased because most credits are nonrefundable. For example, if your tax liability is $5,000 and you're entitled to $7,000 in nonrefundable credits, you'll owe the IRS nothing because your $5,000 tax debt is erased by the credits, but the IRS will keep the $2,000 balance.
Contrast this to refundable credits. If you have more refundable credits than you have tax liability, you'll receive a refund for the balance. The earned income tax credit and the additional child tax credit are two examples of refundable credits. Your tax refund will include the extra income tax that was withheld from your pay as well as any tax credit excess that didn't go toward erasing your tax debt. You'll get more money back from the IRS than you actually paid in.
Carryover Tax Credits
A few credits can be carried from one year to the next so you don't lose any of the excess even if they're nonrefundable. Sometimes they can even be carried back to previous tax years. The foreign tax credit, the adoption tax credit and the residential energy credit allow carryovers as of 2016.
The Bottom Line
Your net tax liability—as opposed to your gross tax liability—is the tax you're responsible for paying after you apply the tax credits you're entitled to. Your net tax liability is found on the line called "total tax" on your tax form. That's line 63 on the 2016 Form 1040, line 39 on Form 1040A and line 12 on Form 1040EZ. Most credits are applied to and reduce this amount on Forms 1040 and 1040A. Credits are applied before line 12 on the 1040EZ.
NOTE: Tax laws and forms change periodically. The above information may not reflect the most recent changes. Please consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and it is not a substitute for tax advice.