The Advantages of Refundable Tax Credits

Refundable credits are some of the best tax breaks out there

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Tax credits and tax deductions are two different things. Both can save you money on taxes, but credits will save you more, and some are better than others because they're refundable.

Here's what you need to know about the different types of tax credits available.

Key Takeaways

  • Tax deductions reduce your taxable income, while tax credits reduce the tax you owe.
  • With refundable tax credits, you can receive a refund if the credit is larger than the amount of tax you owe.
  • However, most tax credits are not refundable.
  • Tax credits are useful for offsetting other taxes that normally can't be reduced in other ways.

Tax Credits vs. Tax Deductions

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 2021, and claim the standard deduction of $12,550, for example, you would only be taxed on $37,450 of your 2021 earnings.

Note

The standard deduction increases a little annually to keep up with inflation. It is $12,950 for the 2022 tax year for single filers.

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. For example, you would only owe the IRS $1,000 if, initially, you were to owe $3,000 on that tax return and then claim a $2,000 credit. Depending on your overall tax situation, this can save you some money on Tax Day.

Tax credits are generally worth more to low-income taxpayers than deductions, but the opposite is true for tax deductions. 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. Still, refundable credits can put some cash in your pocket if there's any amount 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.

Note

Both refundable and nonrefundable tax credits are entered on Schedule 3 of IRS Form 1040.

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 essentially evaporates—the IRS gets to keep it.

Offsetting Other Taxes

Refundable credits 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.

The following credits apply to the 2022 tax year.

The Earned Income Tax Credit

The Earned Income Credit (EITC) is designed for low-income working people. The maximum credit for the 2022 tax year is $6,935 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 and 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 is normally $2,000 per child, and $1,400 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).

Note

The American Rescue Plan Act of 2021 increases the Child Tax Credit to $3,600 for each child under the age of six and to $3,000 for children over the age of six through age 17. The credit hasn't previously included 17-year-olds—the cutoff had been age 16. However, these rules are applicable only in the 2021 tax year, the return you file in 2022.

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 post-secondary education.

The Premium Assistance Tax Credit

Under certain circumstances, a taxpayer 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.

The Credit for Social Security Tax

The credit for excess Social Security tax withheld from your pay isn't technically a "tax credit," but it can still result in money coming back to you. 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—in this scenario, you would 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.

Tip

The American Rescue Plan Act makes the Child and Dependent Care tax credit refundable for one year only in the 2021 tax year, the return you filed in 2022.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Internal Revenue Service. "Publication 501: Dependents, Standard Deduction, and Filing Information."

  2. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2022."

  3. Internal Revenue Service. "Credits and Deductions for Individuals."

  4. Internal Revenue Service. "2021 Child Tax Credit and Advance Child Tax Credit Payments — Topic C: Calculation of the 2021 Child Tax Credit," select Q C5.

  5. U.S. Congress. “H.R. 1319—American Rescue Plan Act of 2021,” Sec. 9611, Pages 141-142.

  6. Internal Revenue Service. "American Opportunity Tax Credit."

  7. Internal Revenue Service. "Questions and Answers on the Premium Tax Credit."

  8. Social Security Administration. "Contribution and Benefit Base."

  9. Social Security Administration. "2023 Social Security Changes." Page 1.

  10. Internal Revenue Service. "Topic No. 608 Excess Social Security and RRTA Tax Withheld."

  11. Internal Revenue Service. "Credit for Child and Dependent Care Expenses," Pages 1-2.

  12. U.S. Congress. "H.R. 1319—American Rescue Plan Act of 2021," Sec. 9631, Page 156-157.

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