Tax credits: How they work and common examples

As the annual tax filing deadline approaches, most taxpayers look for ways to trim their bill and be as tax-efficient with their money as possible. One way to do that is to look for tax credits you're eligible for. Each tax credit you claim directly reduces your tax liability, which can help you start off your new year financially stronger.

Here's what you need to know about what tax credits are and how they work.

A tax credit is an IRS incentive that reduces your tax liability dollar for dollar. If you qualify for a $500 credit, for example, you'll owe $500 less on your taxes. And if you already paid more tax through payroll withholdings than you owe, tax credits can potentially increase the size of your refund.

Both state governments and the federal government offer various tax credits to help segments of the population that are facing unique financial pressures, such as low-income earners and parents. Tax credits also provide an incentive for taxpayers to make certain choices that advance a policy objective. For example, you can get a tax credit for sending a child to college or purchasing a vehicle that reduces fossil fuel consumption.

The tax code includes dozens of credits, each of which has its own eligibility rules. You have to meet those requirements to claim the credit on Form 1040. Some credits are only available to filers who meet certain income restrictions or who incurred specific expenses during the past year.

You may want to consult with a trusted tax professional to help you determine which credits you may be eligible for.

By the time you've claimed all the credits and deductions you're eligible for, you may not owe any additional taxes for the year. But if you're due a refund, not every tax credit will increase it, even if you have a negative tax liability.

Here's what to know about the three basic kinds of tax credits and how they work:

• Nonrefundable. This type of credit does not increase your tax refund if you don't owe any tax. The credit will reduce your tax liability until it reaches zero, but any part of the credit beyond that is forfeited.
• Refundable. These credits will reduce your tax liability, and if you end up owing nothing, they can increase your tax refund by up to the full amount of the credit.
• Partially refundable. With this credit, only a portion of the amount will increase your refund if you have zero tax liability. The remaining amount is reported as a nonrefundable credit.

Let's say that based on your earned income for the previous year, you owe $1,000 in taxes. You claim a $400 nonrefundable credit, which reduces your tax liability to $600. You're also eligible for a $1,200 credit, $800 of which is refundable. You can use $600 of the refundable portion to reduce your owed tax to zero. Because $200 of the refundable amount is left over, it results in a refund of $200. Since you have no tax liability, you forfeit the $400 nonrefundable portion of the partially refundable credit.

Tax software products and (even better) tax professionals are great at identifying the tax credits you're eligible for. But knowing what kinds of tax credits are available can help you keep your finances tax-efficient and ensure you don't miss out.

The most frequently claimed credits include these:

• Child tax credit. You may be able to claim a credit of up to $2,000 if you financially support a child, including a sibling or foster child, during the year. The refundable portion of the credit—known as the additional child tax credit—is up to $1,600 per eligible child.
• Child and dependent care credit. This credit is available if you hired someone to care for a qualifying child or dependent while you worked or actively looked for work. The nonrefundable credit is equal to a percentage of the amount you paid a provider for the care of a qualifying individual, up to a limit of $3,000 per child or $6,000 for multiple children.
• Adoption credit. This nonrefundable credit helps you recoup certain expenses related to the adoption of a child, including fees and attorney costs. The amount of the credit phases out if your modified adjusted gross income exceeds the limit.
• Earned income tax credit. If you worked last year but earned a low to moderate income, you may qualify for the earned income tax credit. The amount of the fully refundable credit depends on your income, family size and filing status.
• Lifetime learning credit. The tax code offers a break if you paid fees or tuition to a college, university or post-secondary trade school. The nonrefundable credit allows you to claim 20% of your first $10,000 in eligible costs.
• American opportunity tax credit. Some filers may get a bigger break on their college costs with the American opportunity tax credit, which is partially refundable. The credit is equal to 100% of the first $2,000 of qualified expenses per student, plus 25% of the next $2,000 of expenses. You cannot claim both this and the lifetime learning credit, so you'll have to calculate which is more valuable to you.
• Saver's credit. The nonrefundable saver's credit provides an incentive for low- and middle-income filers to contribute to a qualified retirement plan such as a 401(k) or IRA. The percentage of the retirement contribution you can claim as a credit is based on your adjusted gross income and filing status.
• Electric vehicle tax credit. If you purchased a new plug-in electric vehicle or fuel cell vehicle, you may qualify for a tax credit worth up to $7,500. The amount of the nonrefundable credit depends on the battery capacity and when the vehicle was put into use.
• Mortgage interest credit. If you receive a mortgage credit certificate from a state or local government agency, you may be able to claim a credit of up to $2,000 each year, based on the home mortgage interest you paid. Typically, you need to be a first-time homebuyer who meets income requirements to qualify—and you need to buy a home in a designated area of your state.

Because tax credits represent a dollar-for-dollar reduction in your tax bill, taking advantage of these provisions can make it a lot easier to get through filing season. Recognizing some of the more common credits and how they work ensures you get the most benefit. A Thrivent financial advisor can partner with your tax professional to develop an optimal tax strategy based on your situation.