The Advantages of Refundable Tax Credits
Refundable credits are one of the best tax breaks out there
Tax credits and tax deductions are two quite different things. Both can save you money on taxes, but credits will save you more and some credits are better than others because they're refundable.
Deductions come off your taxable income. If you're single, you earned $50,000 last year, and you claim the standard deduction, you would only be taxed on $37,800 of your 2019 earnings because that deduction was worth $12,200 in that tax year.
That's not bad, but if you earned $50,000 and you have a tax bill of $3,000 and if you claim a $2,000 tax credit, now you only owe the Internal Revenue Service $1,000. That's a dollar-for-dollar savings right in your pocket.
Some credits only whittle away at what you owe the IRS, but refundable credits can actually put some cash in your pocket if there's any left over after your tax debt is reduced to zero.
Refundable vs. Nonrefundable Tax Credits
When you're eligible to claim a credit that's refundable and if it's more than your total tax liability, the Internal Revenue Service will send you the balance of the money. By contrast, a nonrefundable 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. The IRS gets to keep that part of the money.
Refundable credits are entered on Schedule 3 of the 2019 Form 1040 tax return, and the total from that form is then transferred to line 18 of the 1040. These credits are treated just the same as taxes you've paid in through withholding or estimated quarterly payments.
Some of these lines are different from those on the 2018 Form 1040 because the IRS has revamped the tax return a little once again. The 2019 form is the one you'll file in 2020.
Nonrefundable tax credits also show up on Schedule 3 of the Form 1040, and the total from that schedule is then entered on line 13b of the 1040.
Let's say that you've completed 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 credit that you didn't claim. 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 send you the balance. You'll actually receive $1,000 in cold, hard cash in the form of a refund, even though you didn't pay this money in through withholding from your wages or by making estimated tax payments.
If the credit is nonrefundable, you'll simply erase your $1,000 tax debt—you won't owe the IRS anything—but that extra $1,000 essentially evaporates. The IRS gets to keep it.
If you're entitled to a $500 refund of money that you overpaid through withholding or estimated tax payments, and if you go back and revise your return to claim that $2,000 refundable credit, the IRS will send you a $2,500 refund. You'll receive the $500 you overpaid plus the $2,000 credit.
Offsetting Other Taxes
Refundable credits can offset certain types of taxes that normally can't be reduced in other ways. They can help offset the self-employment tax, the surtax on early distributions of retirement savings, or even other surtaxes such as the nanny tax, the net investment income tax, or the additional Medicare tax.
The following credits are refundable as of the 2019 tax year—the tax return you'd file in 2020.
The Earned Income Tax Credit
The Earned Income Credit (EITC) is designed for low-income working persons. The maximum credit for the 2019 tax year is $6,557—the tax return you'll file in 2020—for taxpayers who have three or more qualifying children.
But this is the maximum credit. It's what you'd receive if all the stars aligned and you met all conditions. The EITC is based on income and qualified dependents so it decreases as you earn more and support fewer children. It drops to $529 if you have no qualifying children, and it's not available at all if you earn too much.
The Child Tax Credit
This credit used to be divided into a nonrefundable portion and a refundable "additional child tax credit" in the 2017 tax year. The additional part of credit represented the refundable portion for select taxpayers who didn't qualify for the full amount of the maximum credit. The maximum credit was $1,000 per qualifying child in 2017.
The TCJA more or less rolled the Child Tax Credit and the Additional Child Tax Credit into one. The phaseout threshold was also increased by the TCJA to allow more taxpayers to claim the credit. A phaseout first reduces, then eliminates the credit entirely for taxpayers who earn too much. The phaseout threshold increased to $200,000 in 2018, or $400,000 if you're married and file a joint return, and they remain at these thresholds in 2019.
The American Opportunity Tax Credit
Up to 40% of the American Opportunity Credit, an educational credit for college expenses, is refundable for the 2019 tax year. The remaining 60% is nonrefundable. The refundable portion is capped at $1,000. The TCJA did not affect this credit.
Students must be enrolled at least part time and the credit covers only the first four years of postsecondary education.
The Premium Assistance Tax Credit
Under certain circumstances, a taxpayer with health insurance coverage purchased through the Health Insurance Marketplace might be eligible for subsidies from the IRS to help defray the cost of premiums. Any subsidies that are not paid out by the IRS directly to the insurance company in advance can be paid to the taxpayer as the Premium Assistance Tax Credit.
The TCJA didn't affect this credit, either, and it's refundable. It's still available for 2019.
The Credit for Social Security Tax
The credit for excess Social Security tax withheld from your pay isn't technically a "tax credit," but it can still result in money coming back to you.
This refund is a reimbursement to taxpayers who might have worked for two or more employers so their total Social Security tax withholding exceeded the maximum limit for the tax year: $128,400 in 2018, increasing to $132,900 in 2019 and to $137,700 in 2020.
Taxpayers don't have to pay the Social Security tax on earnings over these thresholds. You'll get that extra money back if the tax was withheld on these earnings for some reason.
Most Tax Credits Are Nonrefundable
Alas, the most commonly claimed tax credits are not refundable. 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 after it reduces your liability to zero. The same goes for the Adoption Credit, the Savers Credit, and the Lifetime Learning Credit—another credit for paying qualified educational expenses.
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, better yet, consult with a tax professional to be sure. Then, if you're eligible, claim the credit regardless of whether it's refundable or nonrefundable.
After all, the only bad tax break is one you didn't take advantage of.
Tax laws change periodically and the above information might not reflect the most recent changes. Please consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and it is not a substitute for tax advice.
Internal Revenue Service. "2019 EITC Income Limits, Maximum Credit Amounts, and Tax Law Updates," Accessed Nov. 30, 2019.
Internal Revenue Service. "Publication 972 (2018), Child Tax Credit," Accessed Nov. 30, 2019.
Internal Revenue Service. "The Child Tax Credit Benefits Eligible Parents," Accessed Nov. 30, 2019.
Internal Revenue Service. "American Opportunity Tax Credit," Accessed Nov. 30, 2019.
Internal Revenue Service. "Questions and Answers on the Premium Tax Credit," Accessed Nov. 30, 2019.
Social Security Administration. "Contribution and Benefit Base," Accessed Nov. 30, 2019.