April 15 every year is the deadline for filing your annual tax. Although this is not the most joyful event of the year, it is good to know that there are ways to legally reduce the amount of tax you are paying. You can achieve this through tax deductions, but also through three different kinds of tax credits.
Difference between tax deduction and tax credit
First of all, let us make the distinction between tax deduction and tax credit. With tax deduction, you do not reduce the tax you are paying. Instead, you reduce the amount of money which is taxable in the first place. It is usually calculated by subtracting the expenses which are used for making additional income. The remaining sum of money is the one for which you pay the tax.
Tax credit is the sum which reduces the amount of tax you are paying. This means that the same amount of money is taxable, but you will pay less tax due to credits you have.
Types of tax credits
When it comes to tax credits, they come in three forms: Non-refundable tax credit, refundable tax credit and partially refundable tax credit. They all serve to reduce the amount of tax you will pay, but there are certain differences between them.
Non-refundable tax credit
Non-refundable credits are a great way to reduce your tax bill. What’s more, in some cases this type of credit can bring your tax amount up to zero. In other words, you may be free from paying tax. This type of credit includes adoption, child and foreign tax credit and mortgage interest tax credit.
Even though it can reduce the amount of tax you pay, it does not entitle you to tax refund. For example, if you are eligible for $500 non-refundable credit and your tax is $300, you will not have to pay the $300, but you will not get the refund for the remaining $200.
Refundable tax credit
Unlike non-refundable type, the refundable tax credits entitle you to a refund in case the amount of credit is larger than the amount of tax. We will illustrate it with the same example as above. If you are eligible for $500 refundable credit and your tax is $300 – you will be free from paying tax and also get a $200 refund from the IRS. Refundable tax credit includes health coverage tax for individuals, small business health care, earned income tax credit and additional child tax credit, to name a few. If you are entitled to some of these credits, then your tax liability may go beyond zero.
Partially refundable tax credit
In addition to the previous two, there is the third category of tax credits as well – partially refundable credits. They cannot be placed in neither of the previous two categories, because only a part of the credit is refundable. They are a bit more complicated to calculate, and their amount depends on the credit’s type. For example, The American Opportunity Tax Credit falls within this category. If this credit reduces your tax liability to zero, you are entitled to a refund that may reach up to 40%.
Since there are tax deductions and all sorts of credits, make sure to check if you are eligible for them. It can significantly reduce your tax payment and save you money for other purposes.