Understanding How Tax Credits Work

If you were unhappy with last year’s income tax bill, there are several ways to reduce your overall tax burden before the filing deadline arrives. You can try to qualify for as many tax deductions and exemptions as possible. Or, you can find out if you’re eligible to receive a tax credit. Taxpayers often work with a financial advisor to guide them through claiming different types of credits. Let’s take a look at the credits that you could be eligible for and how they work.

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

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

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 a negative number. 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 non-refundable 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 $2,500 non-refundable credit (like the Adoption Tax Credit) but you only owe $1,000, the extra $1,500 won’t be accessible to you. 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. So for the tax year 2025, which has to be filed by April 15, 2026, single tax filers who saved for retirement and had an AGI under $38,250 could qualify for up to a maximum credit of $1,000 ($2,000 for married taxpayers filing jointly).

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):

Energy Efficient Home Improvement Credit
Residential Clean Energy Credit
American Opportunity Tax Credit
Lifetime Learning Credit
Child Tax Credit
Premium Tax Credit
Foreign Tax Credit
Mortgage Interest Credit
Low-Income Housing Credit
Clean Vehicle 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.

Related Article: What Can You Deduct at Tax Time?

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.

With the Earned Income Tax Credit, the 2025 tax year, the credit is worth up to $8,046 (for families with at least 3 children) and married couples filing jointly can qualify with up to $68,675 in income. To get the credit, your earned income and adjusted gross income can’t be higher than the IRS limit. How you qualify, and how much you qualify for, will depend on your income and how many children you have, as well as your tax filing status.

Congress has the authority to keep or eliminate federal tax credit programs. One example includes the elimination of the Employer Wage Credit for Activated Military Reservists. This program helped small businesses who paid National Guard and Reserve members part of their regular salaries even after they were called to serve.

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

Tax credits and deductions both cut your tax bill, but they work in different ways. A credit directly reduces what you owe the IRS, dollar-for-dollar. A deduction lowers your taxable income, which then reduces the amount of tax owed based on your bracket. Knowing this difference can help you see where the bigger savings come from.

For example, in 2025 a single filer earning $60,000 in wages and taking the standard deduction of $15,750 would have $44,250 in taxable income. At a 22% marginal tax rate, a $1,000 deduction—such as an IRA contribution—would lower taxable income to $43,250 and save $220 in taxes. By contrast, a $1,000 nonrefundable tax credit—like the Child and Dependent Care Credit—would reduce the bill by the full $1,000.

Refundable credits can go further. If that same filer qualified for a $1,500 Earned Income Tax Credit, but owed only $1,000 in tax, the IRS would refund the extra $500. In this case, the credit not only eliminated the tax owed but also created a refund. Deductions never produce this type of benefit.

There are also times when deductions are more useful. Imagine a married couple filing jointly in 2025 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 $31,500. By itemizing, they reduce taxable income more than the standard deduction would allow, lowering their bill. If they also qualify for credits—such as the Child Tax Credit worth up to $2,000 per child—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 $38,500 (single filer in 2025). That one move both reduces taxable income and opens the door to a credit worth up to $1,000, doubling the benefit.

The bottom line is that credits usually deliver the bigger dollar savings, but deductions can create the conditions that make credits possible. In 2025, taxpayers should run the numbers both ways—using the standard deduction versus itemizing, and then adding any credits they qualify for. This combination approach is the clearest path to keeping more of your income.

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 (CTC) 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 (EITC) 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.

The Act 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 help lower Americans’ tax burdens each year. Whether you receive a credit through the purchase of a first home or by making energy-saving adjustments, you can potentially save hundreds or thousands of dollars. By doing some research, you might discover some tax credits that you can use to cut your tax bill for the current tax year or the following one.

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.
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