What Is a Refundable Tax Credit?

There are two main types of tax credits: refundable and nonrefundable. Each of these gives you the opportunity to lower your taxes. Keep in mind that tax credits are different from deductions. A simple way to think about it is that a tax deduction is a reduction of your taxable income; a tax credit is a reduction in tax liability that’s applied after your taxes are tallied.

Refundable Tax Credits Simplified

Refundable tax credits can actually give you a refund, as opposed to nonrefundable tax credits. For instance, if you owe $2,000 in taxes and qualify for a $2,500 refundable credit, you’d receive a $500 refund. This can be exciting when the credit you have is greater than the tax you owe.

Similar to payroll withholding, a refundable tax credit is regarded as a tax payment, which means every dollar of a refundable tax credit is subtracted from your taxes owed. A nonrefundable tax credit, on the other hand, will not get you a refund but can still zero out your tax bill. If you owe, for example, $2,000 in taxes and qualify for a nonrefundable credit of $2,500, you’d owe nothing (but the remaining $500 would go unused).

How Big Are Refundable Tax Credits?

While refundable tax credits vary, some can be substantial. For example, the Earned Income Tax Credit — also known as the EITC — can give you thousands of dollars back and be one of the most valuable parts of your tax return. In many cases, instead of paying taxes, recipients of refundable credits such as the EITC can get a pay day from the government with what is essentially a negative income tax.

Here are some common refundable tax credits to be aware of:

• American opportunity tax credit: If you paid qualified higher education expenses
• Child tax credit: If you have a family with qualifying children under age 17
• Earned income tax credit: If you are under a certain threshold of earned income

Premium tax credit: If you’ve purchased health insurance on the federal health insurance marketplace

Refundable Tax Credit or Nonrefundable Tax Credit?

It’s not always black and white. Some refundable tax credits, such as the child tax credit, have a refundable portion and a nonrefundable portion. Another example is the American opportunity tax credit, which gives up to $2,500 per eligible student. If the credit zeroes out your tax bill, you can have 40% of the remaining amount, up to $1,000, as a refund.

As we mentioned above, keep in mind that nonrefundable tax credits can bring your taxes owed to $0, but they can’t trigger a refund. So, if you have a tax bill of $300 and claim a nonrefundable tax credit of $1,200, you will only receive $300 of that $1,200 credit. You will not get a payment if it brings your balance under $0. This is why some people can’t take full advantage of nonrefundable tax credits — they may only be able to use a portion of it.

Nonrefundable tax credits to be aware of include:

• Child and dependent care credit: If you are a working taxpayer who paid for the care of qualifying children or dependents
• Foreign tax credit: Helps you avoid double taxation if you paid taxes to a foreign country
• Adoption expense credit: If you paid necessary adoption fees
• Retirement savings contribution credit: If you made eligible contributions to an IRA or employer-sponsored retirement plan

Lifetime learning tax credit: If you’re a student and had qualified expenses from institutions of higher education

Also keep in mind that some of these nonrefundable tax credits, such as the foreign tax credit, can be carried forward to future years if they’re not fully used this year.

Why Do Refundable Tax Credits Exist?

Proponents of refundable tax credits say they are a way of income distribution in society, giving back to people of certain family status or levels of income. Policymakers can create incentives for work, motivating some people to go from unemployed to employed.

Available tax credits change from year to year, so be on the lookout because certain credits could change by next year. Congress can extend tax credits or let them expire. The reason these credits exist in the first place is because they are usually a part of a stimulus plan to boost the economy, and oftentimes they are limited to a certain time frame.

Claiming a Refundable Tax Credit

If you want to claim a refundable tax credit, you’ll need a Schedule 5 on your Form 1040. On rare occasions, a tax preparer might help you find tax credits, but more commonly you’ll need to find a tax planner who can assist in identifying which credits are available to you and how you can claim them. Of course, there is also tax planning software that automatically calculates any strategies you are eligible for.

Whether it’s refundable credits, nonrefundable credits or deductions, there are hundreds of tax planning strategies that you can potentially use to lower your taxes next year. Most people end up overpaying the IRS because they don’t know about these opportunities. With our tax rules running to tens of thousands of pages, it’s no wonder!

From changing your business legal entity to renting out your home, there’s a lawful tax strategy that fits almost everyone. This is why we built Corvee, which was created to empower you to make smarter tax decisions. Request a free demo today!