Tax credits reduce the taxes a person or family owes, dollar for dollar. They are different from tax deductions, which decrease a taxpayer’s taxable income and only save them the amount of their marginal tax rate. On the other hand, credits are much more valuable because they don’t depend on a taxpayer’s tax rate. Nonrefundable tax credits can only reduce a taxpayer’s total liability to zero. They cannot exceed that amount or create a tax refund. Taxpayers with both refundable and nonrefundable credits should use their nonrefundable tax credits first to minimize the amount of taxes they owe. Then, they can apply their refundable tax credits to increase their refund. Taxpayers can apply both refundable and nonrefundable tax credits toward their taxes, but it is important to claim nonrefundable credits first. This way, you’ll better understand the total amount of money you will receive as a refund.
Difference between Refundable and Nonrefundable Tax Credit
The main difference between refundable and nonrefundable tax credits is that a refundable credit can give you a refund even if it exceeds your total liability. Nonrefundable tax credits can only reduce your tax liability to zero, but they can still add up to a large amount.
However, there are a few exceptions to this rule. Some nonrefundable credits are partly refundable, such as the partially refundable Earned Income Tax Credit (EITC), the refundable Premium Tax Credit for Health Insurance (PTC), and the refundable portion of the American Opportunity Tax Credit for higher education (AOTC). These types of credits function similarly to a refundable credit: they offset the taxpayer’s federal tax liability, and any remaining amount is paid out as a refund.
Other nonrefundable tax credits, such as the child and dependent care credit, retirement savings credit, elderly or disabled worker credit, lifetime learning credit, adoption credit, general business credit, etc., do not provide taxpayers with a refund unless the credit is greater than their tax liability for that year. However, this doesn’t mean that these tax credits can’t increase the size of a taxpayer’s refund, depending on the amount of payroll withholding they have.
The difference between a tax credit and a tax deduction is that tax credits reduce the actual amount of taxes a taxpayer owes, while tax deductions only reduce the taxpayer’s taxable income. Because of this, tax credits typically result in bigger savings for taxpayers than tax deductions do. This is why it is important for taxpayers to be familiar with all of the nonrefundable tax credits that they may be eligible to claim.