Refundable vs. Non-Refundable Tax Credits
There Are Two Main Types of Credits That Can Reduce Your Tax Bill
Tax credits, available through the IRS, can bring you a substantial savings on your Federal income tax bill.
A tax credit reduces your tax liability dollar-for-dollar. This means that a $500 tax credit actually takes $500 off your tax balance due. A tax deduction, on the other hand, reduces your taxable income and is equal to the percentage of your marginal tax bracket — for example, if you’re in the 25% tax bracket, a $500 tax deduction will save you $125 in taxes (because 0.25 × $500 = $125). Now you can see why a tax credit is more valuable than a dollar-equivalent tax deduction.
However, not all tax credits are created equal. Most tax credits are nonrefundable, which means that any excess amount expires the year in which it is used and is not refunded to you. However, some tax credits are refundable and can actually increase your tax refund.
Refundable Tax Credits
Refundable credits are the most versatile type of tax credit. These credits are treated just like tax payments that you make to the IRS, such as income taxes withheld from your paycheck or estimated tax payments that you make throughout the year. In other words, a refundable credit is subtracted from the amount of taxes you owe (after deductions), similar to the way the tax withheld from your paycheck is subtracted from your total yearly tax liability.
A refundable tax credit is particularly advantageous because it can reduce your tax liability to below zero. If the amount of a refundable tax credit is more than the amount of taxes due, the difference will be given back to you as a tax refund. If you are already owed a tax refund, the refundable credit will be added to increase the amount of your refund.
Here are some examples of refundable tax credits:
- Additional Child Tax Credit
- Earned Income Tax Credit (EITC)
- Health Coverage Tax Credit
- Small Business Health Care Tax Credit
Non-Refundable Tax Credits
Nonrefundable credits are another great way to decrease your tax bill. A nonrefundable credit is subtracted from your income tax liability, up to the total amount you owe. But unlike a refundable tax credit, a nonrefundable credit cannot reduce your tax balance beyond zero. Any unused portion of a nonrefundable tax credit will expire in the year the credit is claimed and cannot be carried over.
Some examples of nonrefundable tax credits include:
- Adoption Tax Credit
- Child Tax Credit
- Foreign Tax Credit
- Mortgage Interest Tax Credit
Partially Refundable Tax Credits
Certain tax credits are considered partially refundable because they fit into both categories. In these cases, only a portion of the tax credit can be refunded to you. This type of credit is a bit more complicated — it can be subtracted from the amount of taxes owed and (to an extent) applied to increase the tax refund.
The American Opportunity Tax Credit (AOTC) is an example of a partially refundable credit. The maximum credit amount is $2,500 per eligible student, per year. If the credit reduces your tax liability to zero, you can receive up to 40% of the remaining credit amount (up to $1,000) as a tax refund.
Whether or not a tax credit is refundable, it is worth the effort to make sure you are claiming every credit that you’re eligible for. Additionally, since the rules and amounts for tax credits change every year, it is important to do the proper research before preparing your income tax return.
For more information about Federal tax credits, please refer to Part Six of IRS Publication 17 (Tax Guide For Individuals).