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With the tax season just around the corner, you may be looking for ways to lower the amount of tax you owe. By reducing the taxes you owe, you can put more money in your pockets.
One of the best ways to reduce your tax liability is tax credits. A tax credit is a form of tax benefit that individuals and businesses can use to reduce their tax liability.
But what is a tax credit? How do tax credits work? What are the different types of tax credits? In this guide, we will discuss everything you need to know about tax credits. So read on.
What Is a Tax Credit?
A tax credit is a type of tax benefit that the government offers to taxpayers. This benefit reduces the amount of taxes you owe, dollar for dollar, as compared to tax deductions that reduce the amount of your taxable income.
Tax credits are offered by local, state, and federal governments to individuals and businesses to encourage desired behaviors that benefit the community, environment, and the economy.
For instance, the Earned Income Tax Credit is offered to balance the burden of Social Security taxes and to encourage people to work. There are also some other tax credits that offset education, adoption, and child and dependent care expenses.
Examples of Tax Credits
There are a huge number of tax credit options that may apply to you. Some of these include:
⦁ Lifetime Learning Credit
⦁ Child and Dependent Care Credit
⦁ Retirement Savings Contributions Credit
⦁ Earned Income Tax Credit
⦁ Premium Tax Credit
⦁ American Opportunity Tax Credit
You can find a complete list of all tax credits available for individuals on the IRS website.
How Does Tax Credit Work?
While other tax benefits reduce the taxes you owe indirectly, tax credits have a direct reduction on your owed taxes. They are applied directly to the amount of taxes you owe.
So first, you will need to calculate your tax deductions to determine your amount of taxable income. Next, you will need to calculate the amount of taxes you owe.
From that, you can subtract your tax credits to find the actual amount of taxes you owe.
For instance, if you owe $4,000 in taxes but you qualify for a $500 tax credit, you can subtract this amount from the amount owed. After applying the tax credit, you will owe $3,500 in taxes.
Here’s how you can apply for tax credits:
- Find out which tax credits you qualify for.
- Find and claim the tax credits you want to apply for by following the instructions on your 1040 tax form.
- Attach any supporting documentation such as invoices, records, receipts, or forms.
Types of Tax Credits
There are several different types of tax credits, some of which include refundable tax credits, non-refundable tax credits, and premium tax credits.
What Is a Refundable Tax Credit?
A refundable tax credit, as its name suggests, gives you a tax refund by reducing the taxes you owe to zero. It is applicable in situations where the tax credits are higher than the amount of taxes owed.
In such cases, the remaining tax credit is refunded to the individual or business in the form of a tax refund.
For instance, if you owe $4,000 in taxes but qualify for a $5,000 tax credit, the taxes you owe will be reduced to zero and you will get a tax refund of $1,000.
What Is a Non-Refundable Tax Credit?
A non-refundable tax credit lowers the taxes you owe to zero. However, it does not give you a tax refund. If you qualify for a non-refundable tax credit that is bigger than the taxes you owe, you will not get a tax refund. Only the taxes you owe will get to zero.
For instance, if you owe $4,000 in taxes but qualify for a $5,000 non-refundable tax credit, the taxes you owe will be reduced to zero but you will not get any tax refund.
What Is a Premium Tax Credit?
The Premium Tax Credit is a federal tax credit that allows you to buy health insurance from eligible health insurance exchanges. It is immediately available when you register for an insurance plan so that you have access to health insurance immediately. You won’t have to wait until you file your taxes.
It is actually a type of refundable tax credit that the IRS pays to individuals and families whose income is equal to or above the federal poverty level. It is paid to those who buy health insurance from the eligible exchanges in their state.
You can use this tax credit to reduce the amount of monthly insurance premium you pay.
Conclusion
So that’s all, folks! Now that you know what a tax credit is and how it works, you can easily identify which tax credits you qualify for and apply for them to pay reduced taxes. Tax credits have a direct impact on the amount of taxes that you owe. So they are the best way to reduce your taxes.
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