Understanding How Tax Credits Work

When it comes to lowering your tax bill, not all savings are created equal. Tax credits and deductions may sound similar, but they work in very different ways, and the difference can mean hundreds or even thousands of dollars in your pocket. While deductions reduce your taxable income, credits directly cut what you owe, making them especially valuable in many cases.

Consider working with a financial advisor to take advantage of the right credits and deductions or to help you create a longer-term financial plan.

What Is a Tax Credit?

A tax credit lowers the amount of money you must pay the IRS. Not to be confused with deductions, tax credits reduce your final tax bill dollar for dollar. That means that if you owe Uncle Sam $5,000, a $2,000 credit would shave $2,000 off your total tax bill and you would only owe $3,000.

Unlike the value of tax deductions, which reduce your taxable income, the value of tax credits doesn’t hinge on marginal tax brackets. So the value of a tax credit for a wealthy person who pays a high marginal tax rate would be the same as the value of someone making a lot less money who pays a lower rate.

Tax deductions lower your taxable income or the amount of your money that’s subject to taxation. You can get a deduction for your IRA contributions, for example. Instead of paying taxes on a $50,000 salary, you’d be paying taxes on a smaller amount once you deduct your IRA contributions.

Tax credits by comparison are a bit harder to come by. They usually take the form of incentives that encourage certain actions or serve as benefits for low-to-moderate-income individuals who meet certain requirements.

Types of Tax Credits

Generally, tax credits can be refundable or nonrefundable. When you have a refundable tax credit like the Earned Income Tax Credit, you receive part of the credit as a tax refund if it reduces your tax bill to below zero. In other words, if you receive a $1,000 refundable tax credit but your tax bill is only $500, you’ll get a $500 tax refund.

With a nonrefundable tax credit, on the other hand, you won’t end up with a refund if your tax liability falls below zero. So if you have a $5,000 nonrefundable credit but you only owe $1,000, you won’t receive a $3,500 refund. Some tax credits are partially refundable, meaning that part of the credit can be added to your tax refund.

As an example of a tax credit, let’s break down the Saver’s Credit, which allows taxpayers to claim a percentage of their retirement account contributions (either 50%, 20% or 10%) based on their filing status and adjusted gross income.

For tax year 2026, which has to be filed by April 15, 2027, single tax filers who saved for retirement and had an AGI under $24,250 can qualify for up to a maximum credit of $1,000. Married couples filing jointly with an AGI under $48,500 can qualify for a credit worth up to $2,000.

Other credits benefit electric car owners or parents with childcare expenses. An exhaustive list is available on the IRS website, but the following are some additional federal tax credits you might be eligible to claim (note that some of these will change after tax year 2025):

American Opportunity Tax Credit
Lifetime Learning Credit
Child Tax Credit
Premium Tax Credit
Foreign Tax Credit
Mortgage Interest Credit
Low-Income Housing Credit
Credit for Tax on Undistributed Capital Gain

There are also state-specific tax credits such as California’s Renter’s Credit. You can find out more about these tax breaks by visiting your state government’s website for tax information.

Tax Credit Cuts and Changes

From time to time, the government makes changes to tax credits. Some programs are extended or expire after a certain period. And some have income thresholds that go up or down from one year to the next.

In 2026, the Earned Income Tax Credit is worth up to $8,231 (for families with at least 3 children). How you qualify for the credit, and how much you qualify for will depend on your income and how many children you have, as well as your tax filing status. For example, married couples filing jointly can qualify with up to $70,244 in income while all other filers can qualify if their income doesn’t exceed $62,974.

Congress has the authority to keep or eliminate federal tax credit programs. Keep in mind that expiring or eliminated programs can be extended retroactively, letting taxpayers claim certain credits that have already expired. When changes are made, families and businesses are affected in a variety of ways. In some cases, they can be left at a financial disadvantage when there are major adjustments.

How to Choose Between Tax Credits and Deductions

Refundable tax credits can generate a refund if the credit exceeds the amount of taxes you owe.

When reducing your tax bill, understanding the difference between tax credits and deductions is essential. Both can lower what you owe, but they work in different ways, and choosing the right one can have a meaningful impact on your overall savings.

Tax deductions reduce your taxable income, which lowers the amount of income subject to tax. Tax credits, on the other hand, directly reduce your tax bill dollar for dollar. Because of this, credits are often more valuable than deductions of the same amount.

In many cases, tax credits provide greater savings because they directly reduce your tax liability. For example, a $1,000 tax credit lowers your tax bill by $1,000, while a $1,000 deduction only reduces your taxable income. Credits can be especially beneficial if you qualify for refundable credits, which may result in a refund even if you owe no taxes.

There are also times when deductions are more useful. Imagine a married couple filing jointly in 2026 with $120,000 of income, a mortgage and state/local taxes. Their itemized deductions add up to $38,000, which is higher than the joint standard deduction of $32,200. By itemizing, they reduce taxable income more than the standard deduction would allow, lowering their bill. If they also qualify for credits, they can stack those savings on top.

Credits and deductions can interact. For example, a worker who contributes $3,000 to a traditional IRA lowers adjusted gross income, which might bring their income under the Saver’s Credit threshold of $24,250 (single filer in 2026). That one move both reduces taxable income and opens the door to a credit worth up to $1,000, doubling the benefit.

Not everyone qualifies for every credit or deduction, and many have income limits or phaseouts. Understanding the rules for each option is important to ensure you’re maximizing your benefits. Reviewing eligibility requirements can help you determine which approach offers the greatest advantage.

Choosing between credits and deductions isn’t always an either-or decision, many taxpayers use both. The key is understanding how each fits into your broader tax strategy. Working with a tax professional can help you identify opportunities and optimize your overall tax savings.

How the One Big Beautiful Bill Act (OBBBA) Affects Credits

The One Big Beautiful Bill Act (OBBBA) makes several changes to tax credits beginning in 2026, while keeping many of the TCJA rules in place. These changes affect families, low- and middle-income households, and higher earners differently.

The Child Tax Credit is expanded under OBBBA. The credit increases to $2,200 per child under 17, with a phaseout starting at $200,000 for single filers and $400,000 for married couples. The refundable portion also grows, meaning families with low income can claim a larger refund even if they owe little or no tax.

The Earned Income Tax Credit sees higher maximum amounts, particularly for families with three or more children. The income thresholds are adjusted upward, broadening eligibility for working households. This provides direct relief to lower-income workers, although eligibility still depends on filing status and number of dependents.

At the same time, OBBBA extends the Saver’s Credit, which helps taxpayers who contribute to retirement accounts like IRAs or 401(k)s. The credit percentages remain at 50%, 20% and 10% of contributions, but income limits are raised, making it available to more middle-income savers.

OBBBA also adjusts or removes some smaller credits. The Adoption Credit and Lifetime Learning Credit are retained with higher income phaseouts, but the Nonbusiness Energy Property Credit is eliminated. Lawmakers argued that renewable energy and electric vehicle incentives, kept through separate credits, better target environmental policy.

For households, the effect of OBBBA is clear: larger child- and work-related credits for families, expanded retirement savings incentives for middle earners, but fewer small targeted credits. The overall direction is to simplify credits while steering tax relief toward parents and workers.

Bottom Line

Tax credits can reduce your overall tax bill by offering savings for actions such as buying a first home or making energy-efficient upgrades.

Tax credits and deductions both help reduce your tax burden, but credits often provide greater value because they directly lower what you owe. The best approach depends on your income, eligibility and overall tax situation. By understanding how each works and using them strategically, you can maximize your savings and make more informed decisions when filing your taxes.

Tips for Planning Your Taxes

There are plenty of tax credits, and a financial advisor can help you find them to minimize your tax burden each year. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you lost money on an investment, a financial advisor who specializes in tax planning can harvest your losses to offset your tax liability.
Tax software can also make filing easier. Our best tax software roundup will help you pick the right one for your needs.
If you want to get ahead of the tax filing deadline, SmartAsset’s free income tax calculator can help you figure out how much you will likely pay in income taxes.