Even the simplest tax returns can have credits and deductions. But what do they do to your bottom line? It’s actually fairly straightforward when you break it out of the tax law legalese. This information also applies to states and several foreign countries that do this the same way the US Government does.
First, you should know there are Deductions, Credits, and Refundable Credits. I spent some time trying to determine real world situations that were similar to help understand the difference between each. The IRS has some tables to explain the differences as well.
Let’s start with Deductions. Deductions reduce the amount of money you are going to be taxed on. Like when a store has a sale. You have $1 off on a $3 item; you will only get charged sales tax on the resulting $2. So if you have a $500 deduction on your taxes, it reduces the amount of money that will be used to calculate your taxes owed by $500.
Check Wikipedia for more on Tax Deductions.
Next, let’s look at credits. I think credits are more confusing. Credits directly reduce your tax owed dollar for dollar. A credit that is refundable can actually mean that the IRS will give you back more money than you paid them in the first place. (No, really, you read that right.) These are different enough that I have decided to explain them separately.
Credits that aren’t refundable are limited to the amount of tax liability you have. So if your tax liability is $500 and you have a $1000 credit, you only get to use $500 of the credit. (But hey, that’s $500 more than you had before the credit, right?) This was a hard situation to determine a real world example for because there are situations where your credit is limited and situations where it is not. There is a manufacturer’s rebate that I have seen that is similar to this, though. It’s the one where they will refund you the entire cost of the product up to X amount. Let’s say a toothpaste company has issued a rebate certificate for the entire cost of a tube of their newest toothpaste up to $5. If you live somewhere in the Midwest, the toothpaste only costs you $4 so you get the full cost back, but not all $5. If you live on the west coast, it costs you $6 so you get $5. This is basically the same way regular credits work.
Refundable credits are not limited to your tax liability. So in this case if your tax liability is $500 and you have a $1000 credit, you actually will still get all $1000. To further demonstrate this, let’s say you paid $500 in taxes with money taken out of your W-2. In doing your taxes, after deductions, your tax liability just happens to work out to exactly $500, so you neither have to pay when you file your return nor are you due a refund. Then you get to the credits section of your tax return and find you are eligible for a $1000 refundable tax credit. Suddenly, you have a refund of $1000. Certainly your first reaction is that there has to have been a mistake. But there isn’t a mistake. Because credits are one to one, the first $500 of the credit has effectively cancelled the amount of taxes you owe. Because the credit is refundable, it means that they are going to give you the rest of the credit back anyway. In this case the credit is like applying a gift certificate to a purchase. You have a $1000 gift certificate, if your purchase is more than $1000 you still have to pony up some dough for the rest of the costs, but if it’s less, you get change back. (This would have to be a paper gift certificate, not those credit card ones that doom you to having a card worth $1.78 floating around in your pocket.)
Wikipedia also has information on Tax Credits.
The IRS has a set of topics on individual Tax Credits as well.
I hope this helps make the impact of credits and deductions on your return a bit clearer.