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Home » Refundable vs Nonrefundable Tax Credits
Tax credits are a crucial factor to evaluate when working to reduce taxable income and thereby the tax liabilities incurred. On this note, tax credits allow taxpayers a dollar-for-dollar reduction in their taxable payments to government if the circumstances allow even a cash refund in certain cases. Nevertheless, not all tax credits affect your tax position in the same way. Amongst tax credits, therefore, the IRS distinguishes between refundable tax credits and nonrefundable tax credits, with different sets of rules and advantages accompanying both classifications. Understanding how these two classifications work will allow you to leverage tax credit opportunities for great savings.
The tax credit means a direct dollar-for-dollar decrease in how much you have to pay for taxes. The main difference between credits and deductions is: deductions lower the amount of your income that is taxed, while credits lower the amounts of your tax liability. For example, if your tax liability was $1,000, and you have a tax credit that qualifies for $500, this would wipe out $500 off of your taxes.
The amount of the tax reduction allowed against your tax liability may depend on whether the tax credit is refundable or nonrefundable.
Refundable tax credits are the more taxpayer-friendly credits as they reduce your taxes to zero, then pay back the remainder as cash. This means that anything above the refundable credit value of what you owe in taxes is actually refunded back to you by the government. Hence, this sort of credit is called an advanced payment of your taxes.
Suppose your tax liability involves $3,000, and you have a refundable tax credit of $4,000; thus, your tax liability would be brought down to zero, after which you would receive $1,000 back.
Refundable tax credits are quite handy because they will bring your tax bill down to zero and they will increase your refund if the credit amount exceeds your tax bill.
On the flip side, the tax credits that would be classified as nonrefundable would only completely offset your tax owed, but should the credit exceed your total taxes due, there will be no refunds generated. Basically, if your nonrefundable credit exceeds your tax return, that excess is lost; that is to say, the excess is not available for use in the next tax year and will not be refunded.
For example, you owe $2,000. You qualify for a nonrefundable tax credit of $3,000. Your tax owed will be reduced to zero, but you will not receive a $1,000 refund.
A nonrefundable tax credit is one in which refund presents are there for some amount of tax credits which can’t be obtained when applying for any tax refund in favor of the taxpayer. We will see some nonrefundable tax credits classified as:
Nonrefundable credits do not give you a refund; however, they are, in effect, good credits, since they lessen your tax burden.
The third type relates to partially refundable tax credits. These types of credits provide some benefits to both refundable and nonrefundable credits. Most generally, a given percentage of the credit is refundable, while the remainder is nonrefundable.
One good example of such a credit is the American Opportunity Tax Credit (AOTC). The AOTC applies to students in higher education and allows for a credit of up to $2,500 each year per student. The remaining amount of the credit after a reduction of tax to zero is refundable, but only up to 40% of the remaining credit amount and only refundable for a maximum of $1,000.
Here is the gist to fully utilize the tax credits: