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What are Federal Tax Credits (2023)

Tax credits are a powerful tool that can help reduce the amount of federal taxes you owe. In this article, we’ll explain what tax credits are, identify a few ways they can be used to reduce your taxes, and explore why the government offers them.

What are tax credits?

Taxes are the money that the government collects from citizens to fund various programs and services. A tax credit is a dollar-for-dollar reduction in the amount of taxes you owe. For example, if you owe $1,000 in taxes and you have a $500 tax credit, your tax liability would be reduced to $500. Tax credits are different from deductions, which only reduce the amount of income that is subject to taxes. Tax credits directly reduce the amount of taxes you owe and in some sense are similar to coupons you can use to reduce your tax bill.

What are the different types of tax credits?

There are two types of tax credits: refundable and nonrefundable. A refundable tax credit means that if the credit is larger than the amount of taxes owed, the taxpayer will receive a refund for the difference. A nonrefundable credit, on the other hand, can only be used to offset the amount of taxes owed and cannot result in a refund.

There are many different tax credits available for a variety of situations. Some examples include the Earned Income Tax Credit (EITC), which is designed to help low- and moderate-income taxpayers, and the Child Tax Credit, which can help parents reduce their tax liability for each child under the age of 17. Tax credits for education, such as the American Opportunity Tax Credit and the Lifetime Learning Credit, can help offset the cost of higher education.

In addition, the government offers tax credits to incentivize certain behaviors or investments. For example, the Energy Efficiency Tax Credit allows taxpayers to claim a credit for making energy-efficient improvements to their homes. The Electric Vehicle Tax Credit can help offset the cost of purchasing an electric vehicle. There are also many tax credits opportunities offered to encourage more investment in renewable energy sources such as solar, wind and geothermal, among other opportunities.

The American Rescue Plan Act 2021 has added new tax credits, such as the Child and Dependent Care Tax Credit, which is increased to 100% of expenses for 2021 and 2022. The act also includes the Recovery Rebate Credit, which is a credit for those who didn’t receive the full $1,400 stimulus check, and the Child Tax Credit, which is increased to $3,000 per child and $3,600 for children under 6 years old for 2021 and 2022.

To claim a tax credit, taxpayers must file their taxes and list the credit on their tax return. Taxpayers will also need to provide documentation and proof of eligibility for the credit. It’s important to note that tax credits can change from year to year

Why does the government offer tax credits?

So why does the government offer tax credits? The main reason is to provide relief for taxpayers who are struggling to make ends meet, and to incentivize certain behaviors or investments that the government views as beneficial to society. Tax credits for lower-income families, for example, help to reduce poverty and provide support for basic needs. Tax credits for education can help make higher education more affordable, while tax credits for energy-efficient improvements can help reduce dependence on fossil fuels and combat climate change.

How do tax credits work in practice?

Andres is a married small business owner living in California with $1,250,000 of income. He expects to pay $593,026 in taxes this year, including $457,353 in federal taxes and $135,673 in state taxes. As a result, he and his wife can expect to keep $656,974 after taxes. Andres and his wife would like to reduce that tax bill so they can save more and retire early.

Tax savings

Andres invest $400,000 in renewable energy projects. In addition to tax credits, tax-advantaged investments typically generate an income stream and grow in value over time, but we’ll set those additional benefits aside for now and focus entirely on the tax credits.

In return for his investment, Andres will end up saving $348,000 in federal taxes and $53,200 in California taxes. To understand how that is possible, we’ll explore two concepts that arise with every tax-advantaged investment: depreciation and direct tax credits.

Depreciation tax savings

Depreciation is the amount of value that an asset loses over time. In the context of tax-advantaged investments, each year’s depreciation is an amount that the investor can write off of their taxes.

In most cases, an investor will be allowed to use 100% of their depreciation in the first year; in practice, this means that they will be allowed to take a tax deduction equal to the full value of their investment — $400,000 in Andres’s case. That $400,000 deduction will amount to a federal tax savings of $148,000 (that is, a $400,000 reduction in income multiplied by his 37% federal marginal income tax rate).

State-level depreciation is more complicated. In California, where Andres lives, the investor will be allowed to depreciate 20% of the asset in the first year and the remaining 80% over the next 5 years. For Andres, that means an $80,000 deduction in the first year (20% of $400,000), which, at California’s highest marginal tax rate of 13.3%, equates to tax savings of $10,640.

All in all, then, Andres can use depreciation to reduce his tax bill by $158,640.

Tax credit savings

In addition to depreciation, most tax-advantaged investments come with simple tax credits. In Andres’s case, the program carries a 50% nonrefundable tax credit, so Andres and his wife will earn a credit of $200,000 in the first year. Critically, this doesn’t mean that Andres’s income is reduced by $200,000. Instead, the credit applies directly to his taxes owed, reducing that overall number by $200,000. Because the credit is nonrefundable and is applied after depreciation and other tax write offs, Andres could theoretically reduce his liability to zero before using up his credits. That’s not the case in this example, but even if it did happen, Andres could apply his remaining tax credits to previous tax bills or carry it forward to future years.

Tax savings

Tax credits are a valuable tool that can help reduce your federal tax liability. Do your research and, where necessary, get help from a tax professional to identify credits for which you are eligible, and then make sure to claim them on your return. With the right information and preparation, you can make the most of the tax credits available to you in 2023 and save money on your taxes.

It’s important to stay updated with the changes in tax credit laws and regulations, as they can change from year to year. Consulting with a tax professional or checking the IRS website can help ensure that you’re taking advantage of all the tax credits for which you’re eligible. By understanding and utilizing tax credits, you can help reduce your tax burden and make the most of the money you earn.