Tax credit: what it is, types, and how to use it legally in the U.S.

The U.S. tax system includes several mechanisms designed to reduce the overall tax burden. One of the most important is the tax credit, a benefit that reduces—dollar for dollar—the total tax a person or business must pay.

In this blog, we explain what a tax credit is, the main types available in the United States, and how to use them correctly to optimize your finances and comply with the law efficiently.

What Is a Tax Credit?

A tax credit is an amount subtracted directly from your income tax liability. Unlike deductions, which reduce taxable income, credits reduce the total tax owed—making their impact more direct and noticeable.

Example:
If a taxpayer owes $3,000 in taxes and qualifies for a $1,000 credit, their tax bill becomes $2,000.

There are two main categories: refundable credits and nonrefundable credits. The former allow you to receive money even if your tax liability is zero, since any excess is refunded. Nonrefundable credits, on the other hand, only reduce the tax owed until it reaches zero, but they do not generate a refund. Both types are important in tax planning, and understanding them helps determine which benefits can be used depending on the taxpayer’s profile.

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Main Tax Credits for Individuals and Families

The U.S. government provides multiple credits to support workers, families, and students. Here are some of the most important ones:

1. Earned Income Tax Credit (EITC)

Designed for low- and moderate-income workers, the EITC can significantly increase tax refunds. Millions of taxpayers qualify every year, yet many fail to claim it due to lack of information.

The credit amount depends on income, filing status, and number of qualifying children. For many families, the EITC represents thousands of dollars in additional refunds.

2. Child Tax Credit (CTC)

The Child Tax Credit reduces your total tax for each qualifying child under age 17 with a valid Social Security number.

In some cases, families may also qualify for the Additional Child Tax Credit, which is partially refundable. This credit helps ease the financial burden of raising children.

3. Child and Dependent Care Credit

If you pay for the care of a child, spouse, or dependent so you can work, study, or seek employment, you may qualify for this credit.

The benefit equals a percentage of eligible care expenses and varies according to household income. This credit not only helps cover childcare or dependent-care expenses but also supports workforce participation.

4. American Opportunity Tax Credit (AOTC)

This credit supports students during their first four years of higher education. It covers part of tuition, materials, required fees, and it is partially refundable, meaning up to $1,000 may be refunded if the credit exceeds your tax liability.

The AOTC is a key tool for helping families manage the high cost of college.

5. Saver’s Credit

The Saver’s Credit rewards taxpayers who contribute to retirement accounts such as a 401(k) or IRA. Depending on income and contribution amounts, taxpayers receive an additional benefit that reduces their tax burden.

Tax Credits for Businesses and Self-Employed Workers

Businesses and entrepreneurs can also benefit from various tax credits aimed at stimulating investment, innovation, and sustainability. Some of the most common include the Research and Development (R&D) Credit, which rewards companies that invest in technological innovation, and clean energy credits, which are designed to support sustainable projects and reduce environmental impact.

Additionally, there are credits for hiring veterans or individuals with disabilities, which aim to promote workforce inclusion, as well as the Foreign Tax Credit, which prevents double taxation when a business pays taxes on the same income both abroad and in the United States.

Foreign Tax Credit: Avoiding Double Taxation

The Foreign Tax Credit is one of the most important credits for those who earn income outside the United States. This mechanism allows you to offset taxes paid in another country so you don’t pay twice on the same income.

If you are a U.S. resident or business and have paid foreign income taxes, you can claim this credit by filing Form 1116 (for individuals) or Form 1118 (for corporations).

To do so, you must report the amount of taxes paid and keep the documentation that supports them. In most cases, choosing the credit is more beneficial than taking a deduction, as it directly reduces the amount of tax owed, while a deduction only reduces taxable income.

Tax Credit vs. Tax Deduction: Key Differences

Although both mechanisms help reduce the tax burden, they work differently. A tax credit is subtracted directly from the tax you owe, while a tax deduction reduces the income on which the tax is calculated.

For example, a $1,000 credit means you will pay $1,000 less in taxes. In contrast, a $1,000 deduction reduces your taxable income, and the savings will depend on your tax rate.

In simple terms, credits usually offer a greater benefit because they have a direct impact on the final outcome of the tax return.

How to Know If You Qualify for a Tax Credit

The IRS offers free tools, such as the Interactive Tax Assistant (ITA), which allow taxpayers to determine which credits they may qualify for.

There are also official guides, such as Publications 596, 503, 970, and 514, that detail the specific requirements for each credit.

In any case, it is essential to verify the income limits and required documentation, as the amounts and conditions may vary from one tax year to another.

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FAQ (Frequently Asked Questions)

What is the difference between a refundable and a nonrefundable credit?

A refundable credit may generate a refund even if no tax is owed. A nonrefundable credit can only reduce tax liability to zero.

Can I claim multiple tax credits in the same year?

Yes. As long as you meet the requirements for each credit, you can claim more than one.

What if I pay taxes in another country?

You may qualify for the Foreign Tax Credit, provided the taxes are on income and properly documented.

Do tax credits change every year?

Yes, limits and amounts often adjust annually.

In Summary

A tax credit is one of the most powerful tools for reducing your tax burden and improving financial planning—for both individuals and businesses. Understanding how these credits work can make a significant difference when filing your taxes.

If you operate a business in the United States, Openbiz can help you structure your company, meet your tax obligations, and take advantage of every available tax benefit—with transparent, professional guidance every step of the way.