Taxes

Image source: Getty Images.

A tax credit is a type of tax incentive that can reduce the amount of money a taxpayer owes the government. Unlike a tax deduction, which reduces taxable income, a taxpayer can subtract a tax credit from the amount of taxes they owe, lowering their tax liability dollar-for-dollar.

How tax credits work

Tax credits reduce your tax liability dollar-for-dollar. For example, if your 2016 Federal income tax is $3,500, and you are entitled to a $1,000 tax credit, it reduces the amount of your tax bill to $2,500. Tax credits are offered by the federal government, and your state or local government may have its own.

A tax credit is designed to incentivize taxpayers to do certain things, or to make certain activities more affordable. The Lifetime Learning Credit is designed to lower the financial burden of continuing education, and the Retirement Savings Contributions Credit is intended to incentivize retirement saving.

Most tax credits are offered as a percentage of certain expenses, up to a maximum amount. In addition, many tax credits are subject to income limitations. For example, there are two tax credits available for higher education expenses, both of which are not available to high-income taxpayers.

Nonrefundable vs. refundable credits

Tax credits can be refundable or nonrefundable. Nonrefundable tax credits can only be used to the extent of the tax liability. For example, if your Federal income tax is $800 and you are entitled to a nonrefundable $2,000 tax credit, your tax liability is reduced to zero -- the remaining $1,200 of the credit is not used.

On the other hand, a refundable tax credit can be paid out, even if the taxpayer's liability would be below zero. The Earned Income Tax Credit is a good example of a refundable credit, which means that taxpayers who are entitled to the credit can receive the full amount, regardless of their tax liability.

Examples of common tax credits

There are too many tax credits available to discuss them all in detail here, but let's look at a few examples to illustrate how tax credits work in practice. (Note: Information is current as of the 2016 tax year.)

American Opportunity CreditThis credit is available to taxpayers who paid tuition, up to the first four years of post-secondary education. It is worth 100% of the first $2,000 of qualified expenses and 25% of the next $2,000, for a maximum value of $2,500. The credit begins to phase out above adjusted gross income of $80,000 (single) or $160,000 (married filing jointly), and 40% of the calculated credit amount is refundable.

Lifetime Learning CreditThis credit can be used if the American Opportunity Credit doesn't apply, as it is valid beyond four years of post-secondary education and does not require the tuition be paid for a degree program. It is worth 20% of up to $10,000 in qualified expenses, so it is worth up to $2,000 per year, and is nonrefundable.

Earned Income Tax Credit (EITC)This is a fully refundable credit designed to save lower-income Americans money on their taxes, and qualification depends on the taxpayer's income and number of qualifying children. Credit maximums range from $510 for taxpayers with no qualifying children to $6,318 for taxpayers with three or more qualifying children.

Retirement Savings Contributions Credit: Designed to encourage low- to moderate-income taxpayers to save and invest for retirement, this credit is available to married couples with AGI of $61,500 or less and to singles earning $30,750 or less. Depending on the income, the credit is worth 10%, 20%, or 50% of up to $2,000 in retirement contributions, per taxpayer. This is a nonrefundable credit.

Credits, deductions, and exemptions

Again, these examples are not intended to be a complete list of tax credits, rather they are just meant to give you an idea of how a few of the more common federal tax credits work.

Keep in mind that while tax credit and tax deduction are often used interchangeably, they refer to two completely different things. A tax deduction simply lowers your taxable income -- for example, if you earned $50,000 this year, a $2,000 deduction would simply lower the amount of income subject to tax to $48,000. Since tax credits reduces your tax dollar-for-dollar, they are usually a more lucrative form of tax break.

A tax exemption is yet another kind of tax break, and refers to an amount of income that is excluded from the taxable income calculation. For example, in addition to credits and deductions, U.S. taxpayers are entitled to a $4,050 personal exemption for themselves, their spouse, and each qualifying dependent.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.