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. Credits save you tax dollars, and they do it in one of two ways. Some whittle away at what you owe the IRS, but others can actually put some cash in your pocket after your tax debt is reduced to zero. These are refundable credits.

Refundable vs. Nonrefundable Tax Credits

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 gets to keep that part of the money.

Refundable tax credits are entered on Schedule 5 of the new 2018 Form 1040 tax return, and the total from that form is then transferred to line 17 of the 1040. These credits are treated just the same as taxes you've paid in through withholding or estimated quarterly payments.

Nonrefundable tax credits show up on Schedule 3 of the new form, and the total from that schedule is then entered on line 12 of the 1040.

An Example

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 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 simply erase your $1,000 tax debt—you won't owe the IRS anything—but that extra $1,000 essentially evaporates.  

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.

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 2018 tax year—the tax return you'd file in 2019.

The Earned Income Tax Credit 

The Earned Income Credit (EITC) is designed for low income working persons. The maximum credit for the 2018 tax year is $6,431 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 the above conditions. The EITC is based on income and qualified dependents so it decreases as you earn more and support fewer children. It drops to $519 if you have no qualifying children, and it's not available at all if you earn too much.

The Child Tax Credit 

The Tax Cuts and Jobs Act (TCJA) increases the maximum child tax credit to $2,000 per child, and it makes $1,400 of the credit refundable as of the 2018 tax year.

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. 

Technically, there's 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 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 is $200,000 for the 2018 tax year, or $400,000 if you're married and file a joint return.

The American Opportunity Tax Credit

Up to 40 percent of the American Opportunity Credit, an educational credit for college expenses, is refundable in the 2018 tax year. 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 2018. 

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 worked for two or more employers and whose total Social Security tax withholding exceeded the maximum limit for the tax year: $128,400 in 2018, increasing to $132,900 in 2019.

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 is somehow withheld regardless.

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—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 obviously 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.