What is a tax credit?

A tax credit is defined as an amount that directly reduces the taxpayer's total tax liability on a dollar-for-dollar basis. This means that if a taxpayer owes $1,000 in taxes and has a tax credit of $200, their remaining tax liability is reduced to $800. This is a key benefit of tax credits as they provide immediate and tangible savings in taxes owed, differing significantly from tax deductions which reduce taxable income rather than tax owed.

In contrast to certain other choices, a tax credit does not simply lower taxable income, which would apply to deductions, nor does it refer to a refund received at the end of the tax year, as a refund pertains to overpayment of taxes. Additionally, the term does not apply to exemptions on state income tax, which are separate provisions allowing taxpayers to exclude certain income from taxation. Understanding these distinctions is vital for effective tax planning and compliance.