By Mike Azzara | American Express Credit Intel Freelance Contributor
5 Min Read | June 26, 2020 in Life
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.
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.
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:
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
|Income tax you prepaid via withholding||$2,100.00||$2,100.00|
|Tax you actually owe||$1,500.00||$1,500.00|
|Tax you owe after credit||$(500.00)||$0|
|Your tax refund||$2,600.00||$2,100.00|
Let’s walk through the table:
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:
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
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.
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.
1 “Refundable,” The Cambridge Dictionary
2 “SCHEDULE EIC (Form 1040 or 1040-SR),” IRS
3 “2019 Instructions for Form 8962,” IRS
5 “SCHEDULE 8812 (Form 1040 or 1040-SR),” IRS
6 “2019 Instructions for Form 8863,” IRS
8 “2019 1040 and 1040-SR Instructions,” IRS