The Advantages of Refundable Tax Credits

Refundable credits are one of the best tax breaks out there

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All tax credits are good 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 you're eligible to claim a credit that's refundable and it's more than your total tax liability, the Internal Revenue Service will send you the balance of the money.

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. The IRS keeps the money.

Refundable tax credits show up in the "Payments" section of Form 1040 beginning at line 64 on the second page. They're treated just the same way as taxes you've paid in through withholding.

Nonrefundable tax credits show up in the "Tax and Credits" section of Form 1040 beginning at line 38 on the second page. 

An Example

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 tax 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 receive $1,000 even though you didn't pay this money in through withholding from your wages or estimated payments.

If the credit is nonrefundable, you'll erase your $1,000 tax debt—you won't owe the IRS anything— but the $1,000 essentially evaporates.  

If you complete your tax return to realize that you're entitled to a $500 refund of money you overpaid through withholding or estimated tax during the year 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.

Another Advantage

Refundable tax 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 tax credits are refundable as of the 2017 and 2018 tax years. 

The Earned Income Tax Credit 

The Earned Income Credit is designed for low 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. It increases to $6,431 in 2018 under the same conditions—you must be married, file a joint return, and have three or more children. 

Again, this is the maximum credit. It's what you'd receive if all the stars aligned so you met all the above conditions. The EITC is based on income and qualified dependents so it decreases as you earn more and support fewer children. It's not available at all if you earn too much. It drops to $510 in 2017 if you have no qualifying children and $519 in 2018.

The Additional Child Tax Credit 

The Child Tax Credit is divided into a nonrefundable portion and a refundable portion for the 2017 tax year, although that changed in 2018. The "additional" part of credit represents the refundable portion for select taxpayers who don't qualify for the full amount of the maximum credit. They must meet some criteria as well. The maximum credit is $1,000 per qualifying child for 2017. 

The Tax Cuts and Jobs Act (TCJA) passed in December 2017 increases the maximum credit to $2,000 per child and makes $1,400 of the credit refundable. Technically, there is no longer an "additional" child tax credit because the new law rolled the child tax credit and the additional child tax credit into one.

The phaseout threshold is also increased in 2018 to allow more taxpayers to claim the credit. A phaseout first reduces then eliminates the credit entirely for taxpayers who earn too much. 

The American Opportunity Tax Credit

Up to 40 percent of the American Opportunity Credit, an educational credit for college expenses, is refundable in both the 2017 and 2018 tax years. The remaining 60 percent 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 costs. 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 available in both 2017 and 2018. 

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 worked for two or more employers and whose total Social Security tax withholding exceeded the maximum limit for the tax year. You get that extra money back when this happens. 

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 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 obviously change yearly. Visit the IRS website or 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.