Tax credits can reduce your tax bill or give you a bigger refund, but not all tax credits are created equal. While most tax credits are refundable, some credits are nonrefundable, but before we take a look at the difference between refundable and nonrefundable tax credits, it’s important to understand the difference between a tax credit and a tax deduction.
Tax credits reduce your tax liability dollar for dollar and are more valuable than tax deductions that reduce your taxable income and tied to your marginal tax bracket. Let’s look at the difference between a tax credit of $1,000 and a tax deduction of $1,000 for a taxpayer whose income places them in the 22% tax bracket:
- A tax credit worth $1,000 reduces the amount of tax owed by $1,000–the same dollar amount.
- A tax deduction worth the same amount ($1,000) only saves you $330, however (0.22 x $1,000 = $220). As you can see, tax credits save you more money than tax deductions.
Tax Credits: Refundable vs. Nonrefundable
A refundable tax credit not only reduces the federal tax you owe but also could result in a refund if it more than you owe. Let’s say you are eligible to take a $1,000 Child Tax Credit but only owe $200 in taxes. The additional amount ($800) is treated as a refund to which you are entitled.
A nonrefundable tax credit, on the other hand, means you get a refund only up to the amount you owe. For example, if you are eligible to take an American Opportunity Tax Credit worth $1,000 and the amount of tax owed is only $800, you can only reduce your taxable amount by $800–not the full $1,000.
Refundable Tax Credits
- The Earned Income Tax Credit
- The Child and Dependent Care Credit
- The Saver’s Credit
Nonrefundable Tax Credits
Examples of nonrefundable tax credits include:
- Adoption Tax Credit
- Foreign Tax Credit
- Mortgage Interest Tax Credit
- Residential Energy Property Credit
- Credit for the Elderly or the Disabled
- Child Tax Credit (tax years prior to 2018)
Partially Refundable Tax Credits
Some tax credits are only partially refundable such as:
- Child Tax Credit (starting in 2018)
- American Opportunity Tax Credit