Breaking Down Tax Credits: 9 Essential Terms to Know
May 18, 2023Print
Doing taxes can be overwhelming. Filing them can be challenging on its own, but it’s often made more difficult when considering the many different components and functions of taxes. In a 2013 study, over half of all survey participants held negative sentiments about filing their own income taxes. Among that group, 37% cited finding the tax filing process tedious, confusing, and complicated, in addition to simply fearing that they were making mistakes.
Tax credits are frequently among the more confusing components for the average filer—and the critical anti-poverty tool, the Earned Income Tax Credit, is no exception.
According to the Internal Revenue Service (IRS), four out of five eligible workers claim the federal Earned Income Tax Credit (EITC). This means millions of taxpayers are successfully taking advantage of some of the nation’s most progressive tax policies and putting money back in their own pockets—cash that is integral to the survival of many working American families.
However, the EITC has a complex set of eligibility requirements that change year to year, and too many eligible individuals are still missing out on claiming the money they’re owed, largely due to a lack of awareness and understanding of the credit. This guide aims to address both of those deficits.
Read on for a detailed breakdown of everything that needs to be known about tax credits in nine essential terms.
Basics of Tax Credits
Tax Credits – Tax credits decrease how much someone owes in taxes. This is based on how much the tax credit is worth. This means that if a filer owed $1,000 in taxes and were eligible for a fully refundable tax credit worth $1,400, they would receive $400 in tax refunds.
Tax credits differ from tax deductions, which reduce taxable income based on a person’s income tax bracket. These deductions may also reduce overall tax liability. Generally, tax credits are implemented to support low- and middle-income households while tax deductions are more valuable to high-income earners.
Tax Rates – Tax rates are used to calculate the amount of tax an individual or business pays and vary depending on a person or company’s taxable income. Progressive tax rates often collect more from high-income taxpayers.
Tax Bracket – Tax brackets are ranges of incomes to which different tax rates apply. They can also shift slightly each year due to inflation adjustments.
Tax Credits for Workers and Families
Earned Income Tax Credit (EITC) – EITCs reward and encourage employment by providing a tax break to eligible working individuals and families. 31 states and Washington, D.C. offer a state EITC to supplement the federal credit. The EITC is fully refundable on the federal level and in most states with a state-level EITC.
Child Tax Credit (CTC) – CTCs provide a tax break to families with qualifying children. The primary purpose of a CTC is to offset some of the costs of raising children. In 2021, the federal CTC was expanded, increasing its value from $2,000 per qualifying child to at most $3,600 per child. By the time it expired at the end of 2021, the expansion pulled more than 3 million children out of poverty, making this particular tax credit one of the nation’s strongest anti-poverty tools. President Biden recently announced his plan to reinstate the federal CTC’s 2021 expansion, in an effort to bring back the benefits that reduced child poverty and increased work among parents.
Currently, 12 states offer a state CTC, several of which are modeled after the federal tax credit expansion.
Child and Dependent Care Tax Credit (CDCTC) – CDCTCs help working families afford care expenses for qualifying children and dependents, including a spouse or relative who lives with the filer and cannot mentally or physically care for themself.
Like the EITC, which targets working individuals and families, CDCTCs incentivize employment by deducting a percentage of the cost for childcare or dependent care services incurred from either working or looking for work. The CDCTC is non-refundable, and its value is based on the family’s income and the cost of care services. Currently, 28 states and Washington, D.C. have a state-level CDCTC, most which are modeled after the federal credit.
Tax Rebate – Tax rebates are reimbursements made to taxpayers upon retroactive tax decreases. They are often treated interchangeably with tax credits and gives filers money back against their taxes. However, tax rebates are considered more immediate than the average tax refund because of the government’s ability to implement tax rebates at any time. Tax rebates are typically introduced during economic downturns, so individuals can spend funds immediately and help restimulate the economy.
Filing with Confidence
Individual Taxpayer Identification Number (ITIN) – ITINs are tax processing numbers issued by the IRS for taxpayers who do not have a Social Security Number (SSN). They are commonly issued to non-citizen resident
s. ITINs allow filers without an SSN to file taxes efficiently and apply for eligible tax returns and payments. Although taxpayers with an ITIN are not typically eligible for most tax credits some states are beginning to change this policy. In 2020, California and Colorado became the first states to expand eligibility for their state EITCs to ITIN filers. Other states, such as Maryland, have since done the same.
Levels of Refundability – Tax credits can be fully, partially, or non-refundable. A tax credit is considered refundable if the taxpayer receives the difference between the amount of the credit and the debt owed. This means that if a taxpayer’s tax liability is $100, and they claim a $500 tax credit, they will receive a $400 refund. Certain credits may offer a taxpayer a refund even if they don’t owe tax.
A partially refundable tax credit is when there is a cap to how much of the tax credit can be refunded once it exceeds the debt owed. This also applies to households without any tax liability. Filers who claim a partially refundable tax credit without debt will only receive a portion of the tax credit.
A fully refundable tax credit doesn’t have a cap, while a non-refundable tax credit’s maximum value is capped at a taxpayer’s tax liability. Most tax credits are non-refundable.
The tax system’s many layers are no doubt confusing, and its many nuances too often lead to preventable mistakes – or worse, missed tax credit opportunities – when filing taxes. But the average tax filer stands to gain much by broadening their knowledge of the tax system and tapping into benefits like tax credits.
- Center on Budget and Policy Priorities (CBPP) – Policy Basics: The Child Tax Credit https://www.cbpp.org/research/federal-tax/the-child-tax-credit
- Center on Budget and Policy Priorities (CBPP) – Policy Basics: The Earned Income Tax Credit https://www.cbpp.org/research/federal-tax/the-earned-income-tax-credit
- Internal Revenue Service (IRS) – Credits and Deductions https://www.irs.gov/credits-and-deductions
- Internal Revenue Service – Tax credits for individuals: What they mean and how they can help refunds https://www.irs.gov/newsroom/tax-credits-for-individuals-what-they-mean-and-how-they-can-help-refunds
- National Women’s Law Center – States Can Make Care Less Taxing: Tax Credits Related to Child Care, Tax Year 2022 https://nwlc.org/resource/states-can-make-care-less-taxing-tax-credits-related-to-child-care-tax-year-2022/