How tax credits work: A quick overview

Paying taxes is a fundamental civic responsibility that supports critical public services, including roads, schools, Social Security benefits, and many other government programs. At the same time, qualifying for a tax credit can brighten anyone’s day. Credits provide significant relief to taxpayers by directly reducing income tax liability. Understanding exactly what a tax credit is and how they work can help individuals and families take advantage of valuable opportunities to lower their tax bills and potentially increase their refunds.

Tax credits are dollar-for-dollar reductions in the amount of income tax owed, making them more impactful than tax deductions, which only reduce taxable income. Many tax credits are designed to support specific groups, such as families with children, low- to middle-income households, and older adults. Others encourage activities like higher education spending or saving for retirement.

With a wide range of tax credits available and frequent changes in tax legislation, navigating these options can seem complicated at first glance. However, by learning key terms and identifying commonly claimed credits, even those new to filing taxes can become more informed about important programs and popular credits. This knowledge empowers taxpayers to access the financial benefits they deserve and make the most of available funding, while also allowing tax professionals and agents to provide clients with up-to-date advice on potential benefits.

Refundable vs. non-refundable tax credits

Understanding the difference between a refundable and a non-refundable tax credit is crucial when preparing your federal tax return. Tax credits are generally divided into two categories: refundable tax credits are available when your total tax owed is less than the amount of the credit, and the remaining balance is received as a refund. In contrast, a non-refundable tax credit can only reduce your tax liability to zero; any excess amount beyond your tax due does not result in a refund.

Refundable vs. nonrefundable tax credit options vary from year to year, and eligibility requirements and amounts can change based on current tax laws. Because there is a wide range of tax credits available, taxpayers should review the latest credit opportunities when completing their federal tax return to maximize potential savings.

Common tax credit examples

There are dozens of valuable tax credits available to U.S. taxpayers, ranging from credits for new vehicles to significant support for families with dependents. According to the latest Internal Revenue Service (IRS) data for the 2022 tax year, some of the most frequently claimed tax credits are the Child Tax Credit (CTC), the related Additional Child Tax Credit (ACTC), the Earned Income Tax Credit (EITC), and the Retirement Savings Contribution Credit.

As a proportion of all tax returns, over one-third of filers benefited from the CTC (not to be confused with the Child and Dependent Care Credit (CDCC), which specifically helps offset costs for care of a child or an incapacitated individual). Around 2% of taxpayers claimed the Residential Energy Tax Credit, a key provision of the Inflation Reduction Act (IRA) that rewarded homeowners for making energy-efficient improvements (the program was set to sunset in 2025). While many tax credits are open to all filers, some are limited by income or specific life circumstances, and knowing what you qualify for and which are refundable is crucial when planning your tax strategy.

Tax credits you should know:

• Child Tax Credit (CTC): The child tax credit is a partially refundable tax credit worth over $2,000 per qualifying child under age 17. The Additional Child Tax Credit (ACTC) provides a refundable component for families with low-to-moderate incomes who owe little or no federal income tax, helping cover essential expenses like childcare.
  • To claim: File IRS Form 1040 and include Schedule 8812.
• Earned Income Tax Credit (EITC): A refundable tax credit for low- to moderate-income workers. While not exclusive to families with children, credit amounts increase for those with qualifying dependents.
  • To claim: File IRS Form 1040 and include Schedule EIC (Schedule 8812).
• Foreign Tax Credit (FTC): This nonrefundable tax credit allows individuals who have paid foreign taxes on income also subject to U.S. tax to avoid double taxation.
  • To claim: File IRS Form 1116 with your 1040.
• Retirement Savings Contribution Credit (“Saver’s Credit”): This nonrefundable tax credit rewards contributions to retirement accounts like IRAs and 401(k)s, offering a credit of 50%, 20%, or 10% of contributions based on income.
  • To claim: File IRS Form 8880 with your 1040.
• Lifetime Learning Credit (LLC) and American Opportunity Tax Credit (AOTC): These education credits help offset qualified education expenses for filers, spouses, or dependents. The AOTC is partially refundable, while the LLC is nonrefundable.
  • To claim: File IRS Form 8863 with your 1040.
• Child and Dependent Care Tax Credit (CDCTC): This nonrefundable tax credit helps cover expenses for the care of dependents under age 13, individuals incapable of self-care, or a disabled spouse.
  • To claim: File IRS Form 2441 with your 1040.
• Credit for Other Dependents (ODC): A nonrefundable tax credit worth up to $500 for each qualifying relative not eligible for the child tax credit.
  • To claim: File IRS Form 1040 and include Schedule 8812.
• Net Premium Tax Credits: This refundable tax credit helps individuals and families purchasing health insurance through the Health Insurance Marketplace pay for their premiums.
  • To claim: File IRS Form 8962 with your 1040.

Other important tax credits include the Adoption Credit, the General Business Credit (which aggregates several incentives for sole proprietors and business owners), the Mortgage Interest Credit, and the Credit for the Elderly and Disabled. While previous years offered credits for electric vehicle purchases, those credits are no longer available for cars purchased after September 2025.

Understanding the distinctions between these various tax credit options can help you maximize your refund and lower your overall tax liability each year.

How people use tax credits

Billions of dollars in tax credits are claimed each year, providing significant relief to millions of eligible taxpayers. In 2022 alone, Americans claimed nearly $118 billion through the Child Tax Credit (CTC) and Additional Child Tax Credit (ACTC), according to IRS tax filings. The Earned Income Tax Credit (EITC) resulted in about $60 billion claimed, while Foreign Tax Credits (FTCs) accounted for nearly $33 billion.

Tax credit uptake also varies by income level, especially for key programs like the CTC. For example, eligibility for the CTC is phased out for high-income earners: single filers with adjusted gross income (AGI) above $200,000 and joint filers above $400,000 typically cannot claim the full benefits. In contrast, the EITC is more frequently claimed by lower- and moderate-income households, as it specifically targets working individuals and families with qualifying earned income. Meanwhile, FTCs are often utilized by professionals employed with multinational companies to avoid double taxation on income earned abroad, reflecting a broader income distribution.

This wide range of eligibility highlights how tax credits support different American households. Whether you are supporting a dependent, saving for retirement, or planning for education expenses, understanding which tax credits you may qualify for can make a huge difference. Taking advantage of these tax benefits can substantially reduce your overall tax burden.

Tax credits vs. tax deductions

As mentioned above, understanding the difference between a tax credit and a tax deduction is key to optimizing your tax strategy. Tax credits directly reduce your tax liability on a dollar-for-dollar basis, providing significant incentives or benefits to taxpayers who meet specific qualifying criteria. In contrast, tax deductions work differently: they lower your taxable income before your taxes are calculated, thus indirectly reducing your overall tax bill. Common examples of tax deductions include business expenses, eligible healthcare costs, and standard deductions related to auto loan payments.

To illustrate the impact of tax credit vs tax deduction on your federal tax bill, consider this scenario: If your taxable income is $250,000 with a tax rate of 32%, applying a $3,000 tax deduction decreases your taxable income to $247,000. This adjustment reduces your federal taxes by $960. However, if you qualify for a $3,000 tax credit instead, the entire amount is subtracted directly from the taxes you owe, offering a more substantial benefit than a deduction alone. While both a tax credit and a deduction help reduce your total tax liability, being thoughtful about when and how you claim each can make a significant difference in your overall tax planning. Taxpayers are encouraged to carefully evaluate their options between tax credits and tax deductions to improve their tax outcomes.

What if you’re denied a tax credit?

Tax credit denials happen all the time, and may be due to errors on the side of the filer that can be reversed (such as an issue with a form), mistakes made by the IRS, or a notice that you do not qualify for a specific claim. If this happens to you, review the IRS notice and see if there is anything you can do on your end. Note that filing a claim you are not entitled to can result in serious penalties, such as having to pay back the awarded amount, filing separate documentation during the next tax cycle, paying a fee, or even being banned from filing the claim in the future. Math and clerical errors can happen and are forgivable, but deliberate tax fraud can lead to serious consequences.

Final thoughts

Tax credits are valuable financial incentives designed to directly reduce your tax bill and are available to taxpayers who meet specific eligibility criteria for each credit. These programs can help you better manage necessary expenses, including childcare, education, and retirement planning. Unlike tax deductions, which lower your taxable income, tax credits provide a dollar-for-dollar reduction in the amount of tax owed, making them especially beneficial for qualified filers.

Effective tax planning goes beyond the rush in early April: it’s a calculated, year-round process. If you are uncertain about your eligibility or want to maximize the advantages tax credits offer for your next filing, consulting with a licensed, qualified tax professional can provide personalized guidance and help you navigate the specifics.