Tax Credit

A tax credit comes off your tax bill directly. A deduction comes off your income before the bill is calculated, so it is only worth your marginal rate. A $1,000 credit saves $1,000; a $1,000 deduction saves $220 in the 22% bracket. This is the single most valuable distinction in personal tax planning, and it is routinely reversed in conversation.

Credits divide into three kinds by what happens when they exceed what you owe. A nonrefundable credit can reduce your tax to zero and no further — the excess is wasted, though a few carry forward. A refundable credit is paid out as a refund regardless, which is what allows the Earned Income Tax Credit to deliver money to filers with no tax liability at all. A partially refundable credit splits the difference: the American Opportunity Tax Credit refunds up to 40% of any unused portion.

That ordering matters when several credits apply at once. Nonrefundable credits are applied first, and a filer with a small liability can find a large nonrefundable credit mostly unusable while a smaller refundable one pays out in full.

Almost every credit phases out above an income threshold, measured against adjusted gross income or a modified version of it. The phase-outs are what make year-end moves such as a deductible retirement contribution occasionally worth far more than the contribution itself — dropping below a threshold can restore a credit in one step.

The credits most households encounter are the Child Tax Credit, the Earned Income Tax Credit, the Child and Dependent Care Credit, the two education credits, the Saver's Credit for retirement contributions, the Premium Tax Credit for marketplace health coverage, and the residential clean energy credits. Specific amounts and thresholds change year to year, so the figures matter less than knowing which ones to check.