Which type of credit cannot exceed the taxpayer's federal income tax?

Nonrefundable credits are designed to reduce a taxpayer's liability to zero but cannot result in a refund beyond the amount of tax owed. This means that if a taxpayer's liability is less than the amount of the nonrefundable credit, the unused portion of the credit is not refunded. In contrast, refundable credits can not only reduce the tax owed to zero but can also provide a refund to the taxpayer if the credit exceeds their liability.

Knowing this distinction is crucial for taxpayers when planning their finances, as it can significantly impact their tax outcome. Tax deductions and tax exemptions serve different purposes—deductions reduce taxable income, thus lowering the overall tax owed, while exemptions exclude certain amounts from taxable income without directly providing a credit against tax owed.