Don’t confuse a tax credit with a tax deduction. If you are not sure about the difference, it’s a good time to clear up some tax terms. For the sake of length, this post will only cover tax credits. I cover tax deductions in Tax Deductions: Above-the-Line, Standard, Itemized, and Miscellaneous.
A tax credit directly reduces your tax, dollar for dollar. If you are supposed to pay $5,000 in tax, a $500 tax credit reduces your tax to $4,500. On the other hand, a tax deduction reduces your taxable income, which indirectly reduces your tax. If you are supposed to pay $5,000 in tax, a $500 tax deduction reduces your taxable income by $500. If you are in the 15% marginal tax bracket, it reduces your tax by only $500 * 15% = $75. Therefore a $100 tax credit is worth a lot more than a $100 tax deduction.
Within tax credits, some are refundable tax credits and some are non-refundable tax credits. Here the word refundable often causes confusion because most people refer to the difference between their tax withholding and their total tax as the tax refund.
Tax Refund (R) = Tax Withholding (W) – Total Tax (T)
When they hear that a tax credit is non-refundable, they think they are not going to get the tax credit if they receive a refund versus owe taxes when they file their tax return by April 15, because the credit is, uh, non-refundable. Actually that’s not the case.
Non-refundable does NOT mean it’s not going to be included in the tax refund. It has to do with how it works against your total tax (T) in the above equation. That’s the total tax you are supposed to pay for the year after all the adjustments, exemptions, deductions, and credits are taken into consideration. Most people already satisfied that through tax withholding on their paychecks or by making estimated tax payments.
A refundable tax credit can reduce your total tax to a negative number, which means the government pays you. For example suppose your total tax before the tax credit is $1,500, a $2,000 refundable tax credit means you not only get back everything you paid through tax withholding, but you also get an extra $500 back from other taxpayers. Your total federal income tax for the year is negative.
A non-refundable tax credit can reduce your tax to zero but your tax can’t go below zero. For example suppose your total tax before the tax credit is $1,500, a $2,000 non-refundable tax credit means you will get back everything you paid through tax withholding and that’s it. Your actual benefit from this non-refundable tax credit is $1,500, not $2,000.
If you pay enough taxes, it doesn’t matter whether a tax credit is refundable or non-refundable. Otherwise, a $100 refundable tax credit is better than a $100 non-refundable tax credit.
The following table lists some of the tax credits in alphabetical order. All the links point to the official IRS web site for that topic. Every tax credit has a unique set of qualification rules. Out of 15 tax credits listed here, five are refundable; the other ten are non-refundable.
|Additional Child Tax Credit||Yes|
|American Opportunity Credit||40% refundable|
|Child and Dependent Care||No|
|Child Tax Credit||No|
|Earned Income Credit||Yes|
|Elderly and Disabled Credit||No|
|Excess Social Security Tax Withheld||Yes|
|Foreign Tax Credit||No|
|Lifetime Learning Credit||No|
|Plug-In Electric Drive Vehicle Credit||No|
|Residential Energy Efficient Property Credit||No|
|Retirement Savings Contributions Credit (aka Saver’s Credit)||No|
I doubt anybody can recite all the rules without a reference book. CPAs included. How many credits do you qualify?