You have to file a tax return in order to claim a refundable tax credit (or any kind of tax credit, for that matter). Another benefit of refundable credits is that they can offset certain types of taxes that normally can’t be reduced in other ways. They can help offset the self-employment tax, the surtax on early distributions of retirement savings, or even other surtaxes such as household employee taxes, the net investment income tax, or the additional Medicare tax.
Tax Credits vs. Tax Deductions
To understand how a refundable tax credit works, it may help to first clarify the differences between deductions and credits. Deductions reduce your taxable income. If you’re single, earned $50,000 in 2022, and claim the standard deduction of $12,950, for example, you would only be taxed on $37,050 of your 2022 earnings. The tax savings on standard deductions aren’t bad, but you might be able to reduce your tax bill even further by taking advantage of tax credits. Tax credits directly lower the amount you owe the IRS. For example, if you initially owe $3,000 on that tax return and then claim a $2,000 credit, you would only owe the IRS $1,000. Depending on your overall tax situation, this can save you quite a bit of money on Tax Day. Tax credits are generally worth more than deductions to taxpayers with low-to-moderate incomes. It depends on the rate of the credit and your tax bracket.
Refundable vs. Nonrefundable Tax Credits
Nonrefundable tax credits only whittle away what you owe the IRS. If you don’t owe anything, you won’t benefit from a nonrefundable credit. Refundable credits can not only whittle away at what you owe, but put cash in your pocket if there’s any credit left over after your tax debt is reduced to zero. The IRS will send you the remaining balance of the money as a refund if you’re eligible to claim a credit that’s refundable, as long as the credit is worth more than your total tax liability. By contrast, a nonrefundable credit can only reduce your federal income tax liability to zero. Any part of the credit that’s left over is not refunded back to you. The government gets to keep it.
An Example
Suppose you’ve completed your tax return, only to realize that you owe the IRS $1,000—your withholding or estimated tax payments weren’t enough to cover your entire tax liability for the year. Then you realize that you’re eligible for a certain $2,000 credit that you didn’t claim. You roll up your sleeves and redo your tax return to take it. If that credit is refundable, it will eliminate the $1,000 you owe the IRS, which will send you the balance. You’ll receive a $1,000 check for the refund. If the credit is nonrefundable, you’ll erase your $1,000 tax debt. You won’t owe the IRS anything, but that extra $1,000 of credit essentially evaporates—the IRS gets to keep it.
Types of Refundable Tax Credits
The following refundable credits apply to the 2022 tax year.
The Earned Income Tax Credit
The Earned Income Credit (EITC) is designed for low-income working people. You must have earned income to qualify, but you can’t have too much. The maximum credit is $6,935 for the 2022 tax year ($7,430 for 2023) for taxpayers who have three or more qualifying children. The EITC is based on income and qualifying dependents, so it decreases as you earn more or support fewer children. It’s not available at all if you earn more than a certain limit.
The Child Tax Credit
The maximum Child Tax Credit for the 2022 tax year is $2,000 per child, and $1,500 of the credit is refundable. A phaseout threshold begins to reduce the value of these credits when a single filer’s income reaches $200,000 (or $400,000 for married couples filing joint returns).
The American Opportunity Tax Credit
Up to 40% of the American Opportunity Credit, an educational credit for college expenses, is refundable. The remaining 60% is nonrefundable. The refundable portion is capped at $1,000. Students must be enrolled at least half time, and the credit covers only the first four years of higher education.
The Premium Assistance Tax Credit
Under certain circumstances, taxpayers with health insurance coverage purchased through the Health Insurance Marketplace might be eligible for subsidies from the IRS to help defray the cost of premiums. Any subsidies that are not paid out by the federal government directly to the insurance company in advance can be paid to the taxpayer as the Premium Assistance Tax Credit. This is a refundable credit, so it can either reduce your liability or be paid out directly to you as a refund.
Credit for Excess Social Security Taxes
If you have too much withheld for Social Security taxes, you can claim the excess as a credit. This is a relatively unusual situation, but it can happen when you work two jobs. Social Security taxes aren’t imposed on income beyond $147,000 in the 2022 tax year. That threshold rises to $160,200 in 2023. Taxpayers don’t have to pay the Social Security tax on earnings over these thresholds. If you work two jobs, an employer may not be aware that you’ve surpassed that threshold in your overall annual income. You could get those extra withholdings returned when you file taxes.
Most Tax Credits Are Nonrefundable
The most commonly claimed tax credits are not refundable. Claiming the Child and Dependent Care Tax Credit can reduce what you owe the IRS, but it normally won’t send you a check for any credit that’s left over after it reduces your liability to zero. The same goes for the Adoption Credit, the Saver’s Credit, and the Lifetime Learning Credit.
