When tax time rolls around, tax payers must take advantage of every possible way available to keep from paying more in taxes than they must. One way to do this is through a variety of both refundable and non-refundable tax credits. By definition, a tax credit gives taxpayers a way to reduce their tax liabilities (the amount of taxes they owe) on a dollar-for-dollar basis. In simple terms, this means that for every dollar claimed as a credit, the taxpayer’s obligation goes down by that same amount. Conversely, tax refunds are defined as the amount a taxpayer is due if he or she has overpaid.
Not All Tax Credits Are Created Equal
Unlike deductions that reduce an individual’s taxable income, tax credits are applied directly to the amount of money refunded to the taxpayer. There are two different types of tax credits available to the American taxpayer. These are refundable and non-refundable, and occasionally, there are also partially refundable tax credits. The differences between the main two are significant and can have a major impact on how much of a refund the taxpayer will receive if he or she is owed one.
The Refundable Tax Credit
According to the IRS, a refundable tax credit is one that can result in a check being issued by the IRS regardless of the individual’s tax liability. There are several refundable tax credits available to the average taxpayer including:
- Additional Child Tax Credit
- Earned Income Tax Credit (EITC)
- Health Coverage Tax Credit
- Small Business Health Care Tax Credit
- Making Work Pay Tax Credit
The amount of the refundable tax credit a taxpayer receives is based on how much he or she has paid in minus the amount the IRS says he or she owes. These payments can include income taxes that have been withheld from the individual’s paycheck or for those who are self-employed, their quarterly estimated tax payments. In the event the taxpayer is already due a tax refund, the extra credit will be added to the refund.
The Non-Refundable Tax Credit
The biggest difference between the two types of credit is that while non-refundable tax credits offer taxpayers a great way to reduce their tax liabilities, they can only be deducted from one’s income up to the amount owed. However, while a tax refund can easily exceed the amount the taxpayer has actually paid in, a non-refundable tax credit cannot be used to reduce the person’s tax balance below zero. Anything that goes beyond the amount owed is kept by the Federal Government and cannot be carried over to the next tax year. Among the various non-refundable tax credits available to the taxpayer are:
- Adoption Tax Credit
- Child Tax Credit
- Foreign Tax Credit
- Mortgage Interest Tax Credit
- Premium Tax Credit for Health Insurance (PTC)
Partially Refundable Tax Credits
Finally, there are some tax credits that seem to fall into both categories. These are referred to as partially refundable tax credits because the IRS can only refund a portion of the tax credit. In many instances, the amount can be subtracted from the taxpayer’s total taxes due and then applied to his or her tax refund.
A good example of this is the American Opportunity Tax Credit (AOTC). According to the IRS, the maximum amount a taxpayer can deduct each year is $2,500 for each eligible student. In the event the credit reduces one’s tax liability to zero, he or she may be eligible to receive up to 40% of the extra, up to a maximum of $1,000, in the form of a tax refund.
In the end, refundable vs. non-refundable tax credit shouldn’t matter. Whether a tax credit is non-refundable, partially-refundable, or refundable, it behooves taxpayers to claim every available credit to reduce their total tax liability. At the same time, it pays to keep a close eye on all tax credits and deductions to ensure one takes advantage of everything the IRS has to offer as a way of maximizing tax refunds.