Refundable vs Non-refundable Tax Credits 

By Randall Orser | Personal Income Tax

Tax credits can greatly decrease the amount of taxes you must pay. If you don’t fully understand them, you could be missing out on large cash opportunities. One aspect that often goes unexplained is the difference between refundable and non-refundable tax credits. What is the difference between the two, and how do they affect the amount of tax you owe to the government?

A tax credit is very different from a tax deduction. A deduction is a reduction in the gross income. For example, if you have a gross income of $50,000 for the year, total itemized deductions of $10,000 would make the adjusted gross income $40,000. You have the option to use the standard deduction or itemize your deductions if your total itemized deductions exceed the standard deduction. By increasing the value of your deductions, you lower your taxable income, therefore lowering the amount of total tax you owe.

Tax credits have a larger advantage. After you have calculated your total taxable income and determined how much you owe in taxes, a tax credit will be deducted from that total amount. For example, if you owe the government $3,000 and you qualify for a $1,000 tax credit, you now only owe $2,000. It is a 100% reduction in taxes owed whereas deductions reduce the taxes owed by a much smaller percentage. Basically, you want to get as many deductions and credits as possible, but credits have a larger impact.

Tax credits have nothing to do with how much money was withheld from your check each month for taxes. Don’t even think about how much money is withheld until the very end. The withheld amount also has nothing to do with whether a tax credit is refundable or not. These are two different aspects; do not confuse them.

Many people don’t know that tax credits can be either refundable or non-refundable. If they aren’t done in the right order, you could be losing money owed to you. Fortunately, the forms are set up so that you will automatically calculate them in the right order. However, understanding the difference between the two is beneficial.

First, calculate non-refundable tax credits. A non-refundable tax credit is a credit that cannot exceed your total tax owed. For example, if you owe $3,000 in taxes and your total non-refundable tax credits equal $4,000, your tax owed is $0. You cannot receive back an extra $1,000. There is no refund to the total tax you owe.

Non-refundable credits include basic personal exemption; education credits; child and dependent care credits, adoption credits, etc. Subtracting non-refundable credits first will minimize your total taxes owed.

Now you will have a new taxes-owed amount. Using the above example, you have $0 owed. Calculate your total refundable credits. These included the earned income tax credit, making work pay credit, first time home buyers credit, etc. Let’s say these come to a total of $2,000. These are refundable credits meaning you will have a result of -$2,000 tax. In other words, the government owes you $2,000.

Once you have calculated your taxes owed after subtracting all qualified credits, calculate your entire refund or taxes owed. If you get $2,000 from the government and $5,000 was withheld from your check, your total refund is $7,000. Notice that the amount withheld from your check is separate from the $2,000 refundable credit. You receive an extra $2,000 in addition to the money returned to you that was withheld for tax purposes throughout the year.

Calculating non-refundable credits before refundable credits maximizes your total credit potential. Non-refundable credits are used first, whether they bring your taxes owed down to zero or just reduce them. Refundable credits are calculated last to ensure that all possible refunds are realized. The above example is exaggerated to make the discussion easier. This amount in tax credits is not typical. It depends on what you qualify for. However, make sure you check out each credit thoroughly to ensure you get your maximum return or minimize your taxes owed as much as possible.

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