Question

What is the difference between a refundable versus non-refundable tax credit? Describe the various business-related and individual tax credits available to taxpayers? What are some of the requirements and limitations related to these tax credits?

Answer 1

A tax credit can substantially reduce the amount of tax you owe, or even make your tax refund bigger. However, not all tax credits are alike. Tax credits can be refundable or nonrefundable, and sometimes partly refundable.

Nonrefundable tax credits

A nonrefundable credit essentially means that the credit can’t be used to increase your tax refund or to create a tax refund when you wouldn’t have already had one. In other words, your savings cannot exceed the amount of tax you owe. For example, if the only credit you’re eligible for is a $500 Child and Dependent Care Expenses credit, and the tax you owe is only $200—the $300 excess is nonrefundable. This means that the credit will eliminate the entire $200 of tax, but you don’t receive a tax refund for the remaining $300. All nonrefundable tax credits are listed under the “Taxes and Credits” section of the 1040 and 1040A forms, or under the “Payments, Credits, and Tax” section if using the 1040EZ.

Refundable tax credits

Refundable tax credits, on the other hand, are treated as payments of tax you made during the year. When the total of these credits is greater than the tax you owe, the IRS sends you a tax refund for the difference.

Your tax return form will list all refundable tax credits, such as the Earned Income Credit, in the same section you report your tax payments.

Partially refundable tax credit

As of this writing, only the American Opportunity credit, is partially refundable, up to 40 percent. When you claim this credit for education expenses, Form 8863 separately calculates the refundable and nonrefundable portions, which means you report the amounts in two different sections of your return.

For example, if you calculate a $4,000 American Opportunity credit, a maximum of $1600 may be reported as a refundable tax credit with the remaining $2,400 reported as a nonrefundable credit.