All tax credits are good things, but some are better than others. They're designed to save you tax dollars, and they each do that in one of two ways. Some whittle away at what you owe the IRS, but others can actually put some cash in your pocket
The Difference Between Refundable and Nonrefundable Tax Credits
Tax credits are either refundable or nonrefundable. When a credit you're eligible to claim is more than your total tax liability, the Internal Revenue Service will refund you the difference.
By contrast, a nonrefundable tax credit can only reduce your federal income tax liability to zero. Any part of the credit that's left over is not refunded back to you.
Here's an example. You might complete your tax return only to realize that you owe the IRS $1,000—your withholding or estimated tax payments weren't enough to cover your entire tax liability for the year. Then you realize that you're eligible for a certain $2,000 tax credit that you didn't claim so you roll up your shirt sleeves and redo your tax return to take it. If that credit is refundable, it will eliminate the $1,000 you owe the IRS and the IRS will refund the balance to you—you'll receive a $1,000 refund even though you did not pay this money in through withholding or estimated payments. If the credit is nonrefundable, however, you'll effectively reduce or erase your $1,000 tax debt but the IRS will keep the $1,000 balance.
If you don't owe the IRS money—you complete your return to realize that you're entitled to a $500 refund of money you overpaid through withholding and estimated tax during the year—and if you go back and revise your return to claim that $2,000 refundable credit you've just realized you're eligible for, the IRS will send you a $2,500 refund.
You'll receive that $500 you overpaid through withholding, plus the $2,000 credit.
Don't consider it a waste of time to go back and redo your return if the credit you've realized you're entitled to is nonrefundable. Using it will still reduce your taxable income so you might find that you'll receive a little bit more of a refund for overpaid taxes. But refundable tax credits can offset certain types of taxes that normally cannot be reduced in other ways. For example, they can help offset the self-employment tax, the surtax on early distributions of retirement savings, or other surtaxes such as the nanny tax, the net investment income tax or the additional Medicare tax.
An Easy Way to Differentiate Between Credits
Here's one way to tell the difference between a refundable and a nonrefundable tax credit: Refundable tax credits show up in the Payments section of Form 1040 beginning at line 64. Nonrefundable tax credits show up in the Tax and Credits section of Form 1040 beginning at line 38.
Tax Credits That Are Refundable
The following tax credits are refundable as of the 2017 tax year:
- The Earned Income Credit: This is a tax credit for lower-income working persons. The maximum credit as of the 2017 tax year is $6,318 for married taxpayers who file joint returns and have three or more qualifying children.
- The Additional Child Tax Credit: The child tax credit is divided into a nonrefundable portion and a refundable portion. This additional credit represents the refundable portion.
- The American Opportunity Credit: Up to 40 percent of this tax credit is refundable, although the remainder is nonrefundable.
- The Premium Assistance Tax Credit: Under certain circumstances, a taxpayer with health insurance coverage purchased through a health insurance exchange may be eligible for subsidies from the IRS. Any subsidies that are not paid out by the IRS in advance directly to the insurer can be paid to the taxpayer as a refundable tax credit.
- Credit for excess Social Security tax withheld: This is technically not a "tax credit," at least in the conventional sense, but it can result in money coming back to you. This refund is a reimbursement to taxpayers who worked for two or more employers and whose total Social Security tax withholding exceed the maximum limit for the year.
- Credits from Form 2439: This credit represents an investor's share of tax paid by a mutual fund or real estate investment trust on undistributed long-term capital gains. See the Instructions for Form 8949 and the Instructions for Form 1040 for details.
- The health coverage tax credit: This tax credit expired in 2013 but then, in the middle of 2015, Congress passed a law to revive it through 2019. The IRS has developed special procedures for eligible trade adjustment assistance recipients.
Most Tax Credits Are Nonrefundable
Alas, the most commonly claimed tax credits are not refundable. For example, claiming the Child and Dependent Care Credit can reduce what you owe the IRS, but the IRS won't send you a check for any credit that's left over if it reduces your liability to zero. The same goes for the Adoption Credit, the Savers Credit, and the Lifetime Learning Credit.
But don't assume that a credit is nonrefundable when you're preparing your taxes because these things can change yearly. Visit the IRS website or consult with a tax professional to be sure—then, if you're eligible for it, claim the credit regardless of whether it's refundable or nonrefundable. After all, there's no such thing as a bad tax break.