Tax Credits: Definition, Benefits and Types

Taxes may seem complicated, but they’re also a requirement for running a legitimate business. And through federal tax credits, employers can actually reduce their total tax burden overall.

By understanding tax credits, you can help your organization and people manage their taxes with confidence. Let’s dive into how tax credits work and different types that are available.

What are tax credits?

Tax credits refer to the amount of money a taxpayer can subtract from the taxes they owe. Tax credits differ from tax deductions, which reduce an individual’s taxable income.

Tax credits are divided into three types based on the kind of refund an individual is eligible for. The amount of tax credit can vary drastically based on the type of credit received.

Why are tax credits important?

Tax credits reduce the dollar-by-dollar amount of taxes an individual or organization owes. However, it’s important to understand the different types of tax credits to determine which apply to you or your business. Here are just a few of the potential benefits of tax credits.

Promotes economic growth

Tax credits promote economic growth by providing tax incentives. For example, the R&D credit encourages businesses to innovate and create new:

• products
• processes
• software
• technology
• and more

Similarly, the Work Opportunity Tax Credit (WOTC) encourages businesses to hire from a targeted group facing employment discrimination.

Encourages compliance

To qualify for a tax credit, you must meet certain criteria. Since these requirements are very specific, they encourage taxpayers to abide by them and stay compliant. For example, the Premium Tax Credit (PTC) is available to employees who purchase health insurance via the federal Health Insurance Marketplace. But the tax credit also requires a certain:

• household income
• filing status
• form of preexisting coverage

Ultimately, it’s best practice to understand how a specific tax credit works, regardless of if an individual or organization qualifies for it.

Provides financial assistance

Tax credits, whether refundable or nonrefundable, relieve taxpayers of some financial liability. For example, the Earned Income Tax Credit (EITC) is specifically designed to provide financial assistance to low-to-moderate-income families with qualifying children who earn less than $63,398 annually.

Types of tax credits

Let’s explore the three primary types of tax credits:

• refundable
• nonrefundable
• and partially refundable

If you overpaid your taxes, some tax credits can also be refunded. The government has unique rules for different types of tax credits. Here’s an overview of each category.

Refundable tax credits

A refundable tax credit is a type of tax credit that allows an individual to receive a refund that exceeds their tax liability. This tax credit can also apply if they overpaid in taxes for the previous tax year. For example, if an individual had paid $1,000 in taxes and their tax liability was only $500, they would receive a refund of $500.

Consider these common examples of refundable tax credits.

EITC

The EITC was designed to provide financial assistance to low-to-moderate-income workers with qualifying children who meet certain criteria. By December 2023, roughly 23 million employees and their families had received approximately $57 billion through the EITC. On average, recipients across the country received about $2,541 in 2022 through the EITC.

According to the IRS, to be eligible for EITC in 2024, the worker must:

• have earned an income of below $63,398 annually
• have an investment income below $11,000 (in 2023)
• have a valid Social Security number (SSN)
• be a U.S. citizen or resident alien for at least a full year
• not have filed foreign-earned income

While these are basic EITC requirements, some special rules apply to military members, clergy members, taxpayers and their relatives with disabilities.

Health Coverage Tax Credit (HCTC)

HCTC is a credit that covers 72.5% of qualified health insurance premiums for eligible individuals and their families. Taxpayers have an option to pay 100% of their health insurance premiums for the year and then the IRS will either issue them a refund or give a credit against their federal taxes owed for 72.5% of the premium.

Otherwise, taxpayers may choose to pay 27.5% of their premium to the IRS monthly; the IRS then adds 72.5% to that premium and pays the health administrator 100% of the combined total.

Individuals or family members eligible for this tax credit should be:

• recipients of benefits under the Trade Adjustment Assistance program
• a Pension Benefit Guaranty Corporation payee who is 55 years old or older

PTC

The PTC is a credit available to eligible individuals and families who purchase health insurance through the Health Insurance Marketplace.

You are eligible for a PTC if you meet the following criteria:

• You or a tax family member are enrolled in health insurance through the marketplace for at least one month during a calendar year when the enrolled individual didn’t qualify for coverage through an eligible employer-sponsored plan.
• The health insurance premiums for at least one of those same months are paid by the original due date of your return.
• You fall in the range of certain household income limits.
• You are not filing a tax return using the married filing separately status.
• You must not qualify as a dependent claimed by another individual.

Employee Retention Credit (ERC)

The ERC is a tax credit introduced for businesses to provide them with financial assistance during the COVID-19 pandemic.

This credit helped employers that kept paying their employees during the pandemic if they:

• were shut down due to a government order
• experienced the required decrease in gross receipts within specified eligibility periods in 2020 and 2021
• met the criteria as a recovery startup business during the third or fourth quarters of 2021

Nonrefundable Tax Credits

A nonrefundable tax credit is a type of tax credit that can help a taxpayer bring their tax liability to zero, but they will not get a refund if their credit exceeds the owed amount in taxes. For example, if a taxpayer is eligible for a $1,000 nonrefundable tax credit and owes $600 in taxes, this credit will cover the $600 in taxes, but they won’t receive a refund for the remaining $400.

Here are some examples of nonrefundable tax credits.

Adoption credit

The adoption credit is a type of tax credit available for qualified adoption costs paid to adopt an eligible child, alongside an exemption from taxable income for adoption assistance provided by an employer.

If you adopted or started the adoption process in 2021, you may be eligible for the adoption credit. The credit is nonrefundable, but you can carry over the excess credit for up to five years. The maximum amount taxpayers can claim for 2023 is $15,950 per child. The qualified expenses include:

• reasonable adoption, court and attorney fees
• traveling expenses
• any other necessary costs directly related to the purpose of adopting an eligible child

Child Tax Credit (CTC)

According to the Census Bureau, the CTC lifted 2.9 million children out of poverty in 2021. The CTC offers a tax benefit to eligible families with qualifying children. You might qualify for this credit even if you don’t normally file a tax return. This credit can be claimed for each qualified child who has a valid SSN.

For a taxpayer to qualify for the tax year 2023 CTC, their child or dependent must:

• be under the age of 17 by the end of the year
• be your son, daughter, stepchild, foster child, sibling, stepsibling, half-sibling or a descendant of any of these (such as a grandchild, niece or nephew)
• contribute no more than half of their financial support throughout the year
• have resided with you for over half a year
• be claimed as your dependent on your tax return
• have been a citizen of the United States, a U.S. national or a resident alien of the U.S.
• have not filed a joint tax return with their spouse for the tax year

Retirement Savings Contributions Credit

The Retirement Savings Contributions Credit is the type of credit that you may be eligible for if you were making eligible contributions to your IRA or an employer-sponsored retirement plan.

You may qualify for this credit if you are:

• 18 or older
• not a student
• not claimed as a dependent on another taxpayer’s return

The amount of the credit can vary based on your contributions to an IRA, 401(k), 403(b), 457(b) or other plans. The range of the credit can be 50%, 20% or 10%.

WOTC

The WOTC is a type of federal tax credit available for employers that hire from a specific group of people who have faced employment discrimination. To claim the credit, an employer is required to pre-screen and acquire certification from the relevant designated local agency (aka a “state workforce agency”) confirming that an employee belongs to a targeted group. Employers are required to file either a Form 5884, Form 3800 or Form 5884-C based on whether they are taxable or tax-exempt employers.

R&D tax credit

The R&D Tax Credit is provided by the government to encourage organizations to invest in forward-thinking activities and promote advancement, innovation and economic growth.

According to the U.S. Chamber of Commerce, an estimated 14,000 businesses in the U.S. applied for the R&D tax credit in 2022. Employers are required to file Form 6765 to receive credit. Employers should be able to identify qualifying expenses and provide supporting documentation that shows how these costs meet the requirements under Internal Revenue Code Section 41.

Partially refundable tax credit

A partially refundable tax credit is a type of credit in which the refundable portion is limited to a certain percentage or amount and is never 100%.

Consider the following example of a partially refundable tax credit.

American Opportunity Tax Credit (AOTC)

The AOTC is a type of credit reserved for qualified individuals or students for their educational expenses for the first four years of higher education. The maximum annual amount per student is $2,500. If this credit reduces your total taxes to zero and there are remaining credit amounts, up to 40% of the remaining credit (up to $1,000) may be eligible for a refund.

To be eligible for AOTC, the student must:

• pursue higher education in the form of a degree or other recognized education credential
• enroll in at least half-time for a minimum of one academic period during the tax year
• not have completed the first four years of higher education at the start of the tax year
• not claimed AOTC for more than four tax years
• not have a criminal record of felony drug conviction at the end of tax year

What is the difference between a tax credit and a tax deduction?

Here are some key points to remember when understanding the difference between a tax credit and a tax deduction.

Tax credits help to reduce tax liability and provide multiple benefits ranging from financial assistance to economic growth. By understanding different tax credits, a taxpayer can ensure optimal financial management of their income. Paycom provides tax credit software solutions to identify, secure and administer government incentives.

Tax Credits: FAQ

What is the difference between tax credits and tax deductions?

A tax credit lowers the tax liability, while tax deductions lower the taxable income.

How many types of tax credits are there?

Tax credits are generally divided into three types based on the refunds or credits received: refundable, nonrefundable and partially refundable.

What is the primary benefit of tax credits?

While tax credits have multiple benefits, the primary one is that they provide financial assistance to individual taxpayers and business entities.

Explore Paycom’s resources to learn more about taxes, compliance and more.