Tax Credits: What They Are and How They Work

Key takeaways
* A tax credit reduces the amount of income tax you owe dollar for dollar — generally more valuable than a deduction.
* Credits come in three types: nonrefundable, refundable, and partially refundable.
* Some credits are temporary or have changed over time; eligibility and amounts depend on filing status, income and specific rules.

What is a tax credit?

A tax credit is a dollar-for-dollar reduction in the income taxes you owe. Unlike a tax deduction, which lowers taxable income (and thus reduces taxes at your marginal rate), a credit directly reduces your tax bill. For example, a $1,000 credit lowers taxes owed by $1,000.

Governments use tax credits to encourage policy goals — for example, investing in renewable energy, saving for retirement, pursuing education, or supporting families with children.

How tax credits affect you

Because credits reduce tax liability directly, they typically provide a larger immediate benefit than a deduction of the same nominal value. Whether you actually receive the full value depends on the credit type and your tax liability for the year.

Types of tax credits

There are three basic categories:

Nonrefundable credits

Nonrefundable credits can reduce your tax liability to zero but cannot generate a refund. Any portion that exceeds your tax owed is lost. These credits usually apply only to the tax year in which they are claimed and cannot be carried forward. Examples include certain residential energy credits and some education-related credits in specific years.

Refundable credits

Refundable credits are paid in full even if the credit amount exceeds your tax liability. If the credit reduces your tax bill below zero, you receive the remaining amount as a refund. Common refundable credits include the Earned Income Tax Credit (EITC) and certain portions of the premium tax credit for marketplace health insurance.

Partially refundable credits

Some credits are only partially refundable. For example, the American Opportunity Tax Credit allows a refundable portion up to certain limits (historically up to 40% of the remaining credit or a set dollar cap). The Child Tax Credit has been treated differently across years — portions have been nonrefundable, partially refundable, or temporarily fully refundable depending on legislation.

Recent notable changes (summary)

In 2021, the American Rescue Plan temporarily expanded the Child Tax Credit (higher maximums, fully refundable for that year, and advance payments for many households) and expanded eligibility for the EITC for childless workers. Most of those pandemic-era expansions were temporary and reverted in subsequent years, though some policy changes (like certain eligibility clarifications and adjustments to limits) can persist. Always check current-year IRS guidance for up-to-date rules and amounts.

Example

If you owe $2,000 in taxes and qualify for a $2,500 refundable credit, your tax liability is eliminated and you receive a $500 refund. If that same credit were nonrefundable, your tax bill would be reduced to $0, and the remaining $500 would be forfeited.

Common tax credits (brief)

• Earned Income Tax Credit (EITC) — refundable; supports low- and moderate-income workers; eligibility and amounts depend on income and family size.
• Child Tax Credit (CTC) — rules and refundability have varied; generally reduces taxes for families with qualifying children.
• Child and Dependent Care Credit — nonrefundable credit for eligible care expenses that allow you to work or look for work (IRS Form 2441).
• American Opportunity Tax Credit (AOTC) — partially refundable education credit for qualified postsecondary expenses.
• Lifetime Learning Credit — nonrefundable credit that helps offset postsecondary education expenses (not limited to degree programs).
• Retirement Savings Contributions Credit (Saver’s Credit) — nonrefundable; helps low- and moderate-income taxpayers who contribute to qualifying retirement accounts.
• Residential energy credits, adoption credit, work opportunity credit, and others — each has specific eligibility rules and limits.

Tax credit vs. tax deduction

• Tax credit: Directly reduces your tax bill. A $1,000 credit lowers tax liability by $1,000.
• Tax deduction: Reduces your taxable income. A $1,000 deduction saves you an amount equal to your marginal tax rate multiplied by $1,000 (for example, $220 if you are in the 22% bracket).

Choose between the standard deduction and itemizing deductions based on which yields the larger tax benefit; credits are claimed in addition to whichever deduction approach you use (subject to eligibility).

What to do next

• Check current IRS rules and limits for each credit you think you may qualify for — amounts and rules change over time.
• Keep documentation that supports your claim (receipts, statements, forms such as W-2s, Form 2441, Form 1098-T, etc.).
• Consider consulting a tax professional if you have a complex situation or need help determining eligibility.

Bottom line
Tax credits can substantially lower your tax bill — and refundable credits can even produce a refund. Understand the type of credit, eligibility requirements, and whether any recent or temporary legislative changes apply to the tax year you’re filing.