How Do Tax Credits Work?

When you get paid at your job or earn revenue as a business owner, you owe taxes. Sometimes, a lot of taxes.

One way to owe less is by taking advantage of tax credits and deductions. But unfortunately, many tax deductions and credits have complicated rules. And while many tax credits are for low- to moderate-income people, those people may not be able to afford high-priced accountants. 

To help you sort it out, here are some basics of tax credits, including some of the most common tax credits available for individuals and businesses.

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Tax Credits vs. Tax Deductions

With taxes, generally, the more money you make, the more you have to pay to the IRS every year.

It can get more complicated than that, but the two main things to know about reducing what you owe are tax deductions and tax credits.

Tax deductions

Tax deductions reduce your taxable income.

Everyone is eligible for the standard deduction, which is $14,600 for individuals in 2024. (The standard deduction is less if you are claimed as a dependent on someone else’s return.)

However, you can forego the standard deduction if you can claim a larger amount of itemized deductions, such as mortgage interest, state income tax, property taxes, and charitable contributions. 

Even if you choose the standard deduction, you can still reduce your taxable income even further through deductions such as self-employed health insurance, health savings account (HSA) contributions, traditional IRA contributions, and student loan interest. 

Tax credits

After all deductions, your taxable income — formally, your Adjusted Gross Income (AGI) — determines your federal tax liability, or how much you owe to the government. 

Tax credits reduce this amount dollar-for-dollar as if you had already paid these taxes. 

However, certain non-refundable tax credits cannot reduce your tax liability below zero. 

Related: How Do Taxes Work?

Refundable vs. Non-Refundable Tax Credits

A refundable tax credit is a credit you can get as a refund even if you don't owe any tax. 

Non-refundable tax credits are capped by your tax liability. This means that any non-refundable tax credits that would reduce the taxes you owe below zero are forfeited in that calendar year. 

Some credits are partially refundable, meaning that they are refundable up to a certain limit, and that limit is less than the total potential value of the credit. 

Tax Credits for Individuals and Households

Here are some common tax credits for both individuals and households:

Child tax credit

The child tax credit is worth up to $2,000 per child, with up to $1,700 per child refundable through an additional child tax credit. 

To receive the child tax credit households must have had a minimum of $2,500 income in the calendar year, but not more than $400,000 ($200,000 if filing single). 

As well, the child must:

• Be under 17
• Be listed as a dependent
• Have lived with you for at least six months in the calendar year
• Have provided no more than 50% of their financial support on their own

Child and dependent care credit

The child and dependent care credit allows you to claim childcare expenses that allow for return to work, such as babysitting or childcare costs. The dependent must be under age 13. 

You can claim 20-35% of up to $6,000 ($3,000 if only one dependent) in eligible expenses. 

This is a non-refundable credit, so you must have earned income throughout the year. 

If your taxable income is above $43,000, the tax credit falls to 20% of eligible expenses (up to the cap), but there’s no maximum income limit.  

The IRS has an online tool to determine if you’re eligible for the child and dependent care tax credit.

Earned income tax credit

The EITC is a refundable tax credit targeted at low- to moderate-income families. For 2024, your earned income must be less than $59,899 for individuals and $66,819 for married joint filers. 

For the 2024 tax year, the credit is worth up to $7,830 for households with three or more children, but just $632 with no qualifying children. 

Earned income includes wages, self-employment, and gig-economy income (e.g., selling online), but excludes investment income, social security, and unemployment benefits. 

Education tax credits

There are two education-related tax credits, but households may only claim one per year per eligible student, even if they are eligible for both. 

• The American Opportunity Tax Credit (AOTC) is a partially refundable tax credit worth a maximum of $2,500 per student per year for a maximum of four years. The student must be enrolled at least half-time and pursuing a degree.
• The Lifetime Learning Tax Credit (LLTC) is a non-refundable tax credit worth up to $2,000. It is available for an unlimited number of years and does not have restrictions on pursuing a degree.

Both the LLTC and AOTC phase out at higher income thresholds — $180,000 if filing jointly, otherwise $90,000.

The IRS has an online tool to determine eligibility.

Retirement savers credits

Low- and moderate-income households may receive a tax credit for contributions to work retirement plans. 

Individuals can earn a credit of 10-50% of the first $2,000 contributed to retirement plans such as a 401(k) or 403(b). 

For the 2024 tax year, your AGI must be below $38,250 if an individual or $76,500 if married filing jointly. 

Clean vehicle credit 

Individuals with an AGI below $150,000 (or $300,000 if married filing jointly) are eligible for a credit of up to $7,500 for purchasing a qualified electric or fuel cell vehicle.

Related: Do I Need to File Taxes?

Tax Credits for Businesses

Businesses can also benefit from tax credits. Here are some of the most common ones:

Work opportunity tax credit

The work opportunity tax credit is designed to create diversity in the workplace. It provides a 40% match for the first $6,000 in wages paid for eligible employees.

To be considered an eligible employee, the employee must: 

• Be in their first year of employment
• Work at least 400 hours during the year for the employer
• Be certified as being part of a targeted group, such as veterans, ex-felons, and summer youth workers

Employer-provided childcare credit

This is a non-refundable business tax credit that matches 25% of qualified childcare expenditures plus 10% of qualified child care resources up to $150,000.

Qualified expenditures include:

• Acquiring or expanding property used as a childcare facility
• Operating a childcare facility
• Contracting with a third-party facility to provide childcare

Small business healthcare tax credit

Companies with fewer than 25 full-time employees that pay at least half their employees’ premiums may be eligible for a tax credit of up to 50% of those expenses.

TL;DR: How To Use Tax Credits

While everyone is eligible for the standard deduction on your taxes, there are also plenty of other deductions and credits that can further reduce what you owe to the government at tax time.

Tax credits are available for things like childcare, education expenses, saving for retirement, and even purchasing a clean-air vehicle. Businesses, too, can get credits for providing childcare and healthcare to workers, or for creating a more diverse workplace.

U.S. taxes can be complicated, so if you think you can use a lot of credits or deductions, you may want to speak to a tax expert.

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