American ExpressAmerican ExpressAmerican ExpressAmerican ExpressAmerican Express
United StatesChange Country

What Are Refundable Tax Credits?

Refundable tax credits can get you a “refund” for more money than you paid in taxes in the first place, in return for certain behaviors the government encourages.

By Mike Azzara | American Express Credit Intel Freelance Contributor

5 Min Read | June 26, 2020 in Life

 

At-A-Glance

Many tax credits are “refundable,” which in tax-speak means you might get money back from the IRS whether or not you paid any tax in the first place.

Refundable tax credits are meant to help low- and lower-middle income people, so their phase-outs for qualifying income generally are correspondingly low—though there are exceptions.

 

What Are Refundable Tax Credits?

Refundable (adjective): If an amount of money is refundable, it can be given back to the person who paid it, for example because they need to change their plans.

—The Cambridge Dictionary1

 

When you think “refund,” it’s about getting back money you paid for something, right? So when you hear “refundable,” logic (and the Cambridge Dictionary) says it should refer to a payment you might get back, under certain circumstances. But what do you call money that you get without ever having paid it in the first place? Welcome to the weird and—potentially—wonderful world of refundable tax credits.

 

In tax-speak, a refundable tax credit is one that can help you get money from the IRS whether or not you paid any tax in the first place. There are many refundable tax credits, some of which are fully refundable while others are only partially refundable. All of them have specific and sometimes complex qualifying criteria, the most important of which is usually the income level at which the credit begins to phase out. In general, refundable tax credits are meant to help low- and lower-middle income people, so the qualifying income thresholds are correspondingly low.

 

But not always: A notable exception is the Child Tax Credit, which doesn’t begin to phase out until you hit $200,000 for single people or $400,000 for married couples filing jointly.

 

What Are Refundable and Nonrefundable Tax Credits?

No matter how strange it sounds, you have to stop thinking about “refund” if you want to understand refundable and nonrefundable tax credits. In both cases, they don’t imply anything about whether or not you get a refund on the taxes you paid already. Instead, they’re only about whether or not your tax bill can be reduced below zero:

  • Nonrefundable tax credits can lower the tax you owe to zero, but no lower.
  • Refundable tax credits keep reducing your tax bill below zero, into negative numbers.

 

To illustrate the point, imagine your employer withheld $2,100 in federal income tax from your paycheck and paid it to the IRS on your behalf. But when you calculate your actual income tax bill, it’s only $1,500. If you’re not eligible for any tax credits, you get a $600 refund ($2,100-$1,500). But what if you are eligible? The table below shows what happens if you’re eligible for a refundable or nonrefundable tax credit.

 

Refundable Tax Credits Can Reduce Your Tax Below Zero

  Refundable Nonrefundable
Income tax you prepaid via withholding $2,100.00 $2,100.00
Tax you actually owe $1,500.00 $1,500.00
Tax credit $2,000.00 $2,000.00
Tax you owe after credit $(500.00) $0
Your tax refund $2,600.00 $2,100.00

 

Let’s walk through the table:

  • Nonrefundable tax credit: If you’re eligible for a $2,000 nonrefundable tax credit, your prepaid withholding tax paid ($2,100) doesn’t change, nor does the tax you owe before applying credits ($1,500). The $2,000 credit is subtracted from your tax bill, resulting in negative $500. But remember: a nonrefundable tax credit cannot reduce your tax bill below zero, so the tax you owe only comes down to zero. You get a tax refund for the whole $2,100 that was withheld.
  • Refundable tax credit: Now, look at the refundable column, remembering that refundable tax credits can reduce your tax bill below zero. There, subtracting the $2,000 refundable tax credit from your $1,500 tax bill results in the same negative $500, but this time it counts. You get a tax refund of $2,600—the $2,100 your employer took out of your paychecks all year plus the portion of the refundable credit below zero.

 

How Do Refundable Tax Credits Work?

How do you think refundable tax credits work? Paperwork! Whether atoms (physical paper) or bits (electronic paper), you have to fill out one, two, and sometimes even more, forms for each tax credit you may be eligible for.

 

Here’s a list of the main refundable tax credits and the forms you’ll need to apply for them:

  • Earned Income Tax Credit: To encourage you to work even if you don’t earn a lot, this credit maxes out at slightly more than $6,500 and is fully refundable. It phases out beginning at about $25,000, and is eliminated completely if your income hits $56,000 (for married couples filing jointly). For tax-year 2019, you’ll need Schedule EIC.2
  • Health Care Tax Credit: Technically, this is called the Premium Tax Credit because it’s meant to help you pay part, or all, of your monthly health insurance premium. It’s fully refundable. You’ll want to start with the 2019 Instructions for Form 8962.3
  • Child Tax Credit: This can get you a max of $2,000 for each qualifying child in your care, and up to $1,400 per child is refundable. To determine if you’re eligible, fill out the worksheets in IRS Publication 972 (Child Tax Credit and Credit for Other Dependents4), and then fill out Schedule 8812).5 Don’t be thrown when you see “Additional Child Tax Credit” on form 8812; “additional” in this case refers to the refundable portion of the credit, not the child.
  • Education Tax Credit: Officially, this is the American Opportunity Credit, 40% of which is refundable up to $1,000 per eligible student. Get Form 8863.6

 

Some popular nonrefundable tax credits are the Electric Vehicle credit, the Child and Dependent Care Credit, the Senior Credit (for elderly or disabled), the Saver’s Credit (formerly the Retirement Savings Contribution Credit), and the Foreign Tax Credit (if you paid tax in another country).

 

To get nearly all these refundable and nonrefundable tax credits you’ll need to fill out Schedule 3 of Form 1040,7 in addition to all the other forms. The instructions for that start on—I kid you not—page 95 of the Form 1040 instructions.8

 

Yes, They’re Combinable

It’s important to note that if you’re eligible for more than one tax credit, you can combine them. Not only that, but the nonrefundable credits come off your tax bill first, so that you get the full value of any refundable credits. For example, a married couple with three children and household income less than $56,000 might be eligible for the earned income, child, and childcare credits.

 

The Takeaway

Refundable tax credits can get you “back” money from the IRS—in some cases, even more than you paid in taxes in the first place. Like all tax credits, refundable tax credits are subject to strict qualifications, require you to fill out many forms, and—for most people—are best pursued with the help of a tax professional.

Mike Azzara

Mike Azzara has covered technology and financial services issues for more than 30 years as a writer, editor, publisher, consultant, and analyst for media brands, startups, and established corporations.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

The material made available for you on this website, Credit Intel, is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.