The Advantages of Refundable Tax Credits

Refundable credits are some of the best tax breaks out there

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Tax credits and tax deductions are two different things. Both can save you money on taxes, but credits will save you more, and some are better than others, because they're refundable.

Here's what you need to know about the different types of tax credits available.

Tax Credits vs. Tax Deductions

It may help to first clarify the differences between deductions and credits. Deductions reduce your taxable income. If you're single, earned $50,000 in 2020, and claim the standard deduction, you would only be taxed on $37,600 of your 2020 earnings, because the standard deduction for single taxpayers is worth $12,400 in that tax year.

The standard deduction increases a little annually to keep up with inflation. It increases to $12,550 in the 2021 tax year for single filers.

The tax savings on standard deductions aren't bad, but you might be able to reduce your tax bill even further by taking advantage of tax credits. For example, you would only owe the Internal Revenue Service (IRS) $1,000 if initially you were to owe $3,000 on that tax return and then claim a $2,000 credit. Depending on your overall tax situation, this can save you some money on Tax Day.

Refundable vs. Nonrefundable Tax Credits

Nonrefundable tax credits only whittle away what you owe the IRS, but refundable credits can actually put some cash in your pocket if there's any amount leftover after your tax debt is reduced to zero.

The Internal Revenue Service will send you the remaining balance of the money as a refund if you're eligible to claim a credit that's refundable, if the credit is worth more than your total tax liability. By contrast, a nonrefundable credit can only reduce your federal income tax liability to zero. Any part of the credit that's leftover is not refunded back to you. The government gets to keep it.

Both refundable and nonrefundable tax credits are entered on Schedule 3 of Form 1040.

An Example

Suppose 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 sleeves and redo your tax return to take it.

If that credit is refundable, it will eliminate the $1,000 you owe the IRS, which will send you the balance. You'll actually receive a $1,000 check for the refund. 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.

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 apply to the 2020 tax year.

The Earned Income Tax Credit 

The Earned Income Credit (EITC) is designed for low-income working persons. The maximum credit for the 2020 tax year—which applies to returns filed in 2021—is $6,660 for taxpayers who have three or more qualifying children.

The EITC is based on income and qualifying dependents, so it decreases as you earn more and support fewer children. It drops to $538 if you have no qualifying children, and it's not available at all if you earn more than the limit.

The most a single taxpayer with three or more qualifying children can earn in 2020 is $50,954.

The Child Tax Credit

The Tax Cuts and Jobs Act (TCJA) increased the maximum Child Tax Credit to $2,000 per child, and $1,400 of the credit has been refundable since the 2018 tax year.

A phaseout threshold begins to reduce the value of these credits when a single filer's income reaches $200,000 (or $400,000 for married couples filing joint returns). As with many aspects of TCJA that impact individuals, these credits are set to revert to their pre-TCJA status after 2025. This will reduce both the value of the credit and the income threshold that begins to reduce the credit.

The American Rescue Plan Act of 2021 increases the Child Tax Credit to $3,600 for each child under the age of six, and to $3,000 for children over the age of six through age 17. The credit hasn't previously included 17-year-olds—the cutoff had been age 16. Unfortunately, these rules are applicable only in the 2021 tax year, the return you'll file in 2021.

The American Opportunity Tax Credit

Up to 40% of the American Opportunity Credit, an educational credit for college expenses, is refundable. 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 half time, and the credit covers only the first four years of post-secondary 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 federal government directly to the insurance company in advance can be paid to the taxpayer as the Premium Assistance Tax Credit. This is a refundable credit, so it can either reduce your liability or be paid out directly to you as a refund.

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 is a relatively unusual situation, but it can happen when you work two jobs.

Social Security taxes aren't imposed on income beyond $137,700 in the 2020 tax year. (That will increase to $142,800 in the 2021 tax year.) Taxpayers don't have to pay the Social Security tax on earnings over these thresholds. If you work two jobs, an employer may not be aware that you've surpassed that threshold in your overall annual income—in this scenario, you would get those extra withholdings returned when you file taxes.

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 it won't send you a check for any credit that's leftover after it reduces your liability to zero. The same goes for the Adoption Credit, the Saver's Credit, and the Lifetime Learning Credit.

The American Rescue Plan Act makes this tax credit refundable for one year only in the 2021 tax year, the return you'll file in 2022. You can also claim more expenses.

The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the laws. For current tax or legal advice, please consult with an accountant or an attorney.