How Does the Tax Credit Affect Taxpayers?

Qualifying for tax credits can have you raking in a giant refund.
i Creatas/Creatas/Getty Images

The best tax planning starts long before you file your income tax return. Planning ahead so you can take advantage of tax breaks, such as tax credits, lowers your income tax liability. Understanding how tax credits affect your taxes due and the size of your refund can help you better estimate your income tax liability.

No "Universal" Tax Credit

The government doesn't just hand out tax credits to taxpayers like a sidewalk preacher hands out leaflets to anyone who passes by. Instead, you've got to work for them, or at least do something specific. Each tax credit has a specific set of criteria you must meet. For example, the retirement savings credit requires that you contribute to a qualifying plan, such as a 401k or IRA, and that your income not exceed a specified amount. Other credits, like alternative minimum tax credit and the foreign tax credit, are much more complicated.

Purpose of Tax Credits

When the government wants to get you to do something without mandating it, or to reward certain behaviors, it often uses tax credits. For example, when the government wanted to encourage more people to buy homes in 2008 and 2009, it enacted the first-time homebuyer credit to give a tax incentive for purchasing homes. Even though it wasn't a requirement or a law, people responded to the tax incentive by buying more homes.

Effect on Your Tax Bill

Unlike a deduction, which just decreases your taxable income, a tax credit reduces your actual tax liability. For example, assume you are single and have $50,000 of taxable income, which puts you squarely in the 25 percent tax bracket. If you have a $3,000 tax deduction, your taxable income drops to $47,000 and your tax bill decreases by $750 ($3,000 x 25 percent). If instead of a deduction you have a $3,000 tax credit, skip the multiplication: your tax bill drops by $3,000.

Refundable Versus Nonrefundable

Tax credits are subdivided into two groups: refundable credits and nonrefundable credits. Refundable credits are the more beneficial of the two because you get the benefit no matter what. If you don't have the tax liability for the credit to offset, the government writes you a check for the value of the credit. Nonrefundable credits can only be used to offset your existing tax liability. For example, if you go back to school for a year and have no income (and therefore no tax liability), the lifetime learning credit won't help you because you don't have any taxes to offset.

Can You Still Benefit?

Worried that your nonrefundable credit can't help you because you expect a refund? Check again. Just because you receive a refund doesn't mean you didn't have any tax liability. A refund just means you paid more to the government than you owed, not that you didn't owe anything. For example, if you had $7,000 withheld from your paycheck and had a tax liability of $4,000, you'd get a $3,000 refund. However, if you claim an additional $2,000 nonrefundable credit, your tax liability decreases to $2,000 and your refund jumps up to $5,000.

the nest