What Is the Difference Between a Refundable and a Nonrefundable Credit?
A tax credit can substantially reduce the amount of tax you owe, or even make your tax refund bigger. However, not all tax credits are alike. Tax credits can be refundable or nonrefundable, and sometimes partly refundable.
- Nonrefundable tax credits can reduce the amount of tax you owe, but they do not increase your tax refund or create a tax refund when you wouldn’t have already had one.
- Refundable tax credits can result in a tax refund if the total of these credits is greater than the tax you owe.
- Partially refundable credits can reduce the amount of tax you owe and result in a refund for a portion of the excess credit.
Nonrefundable tax credits
A nonrefundable credit essentially means that the credit can’t be used to increase your tax refund or to create a tax refund when you wouldn’t have already had one. In other words, your savings cannot exceed the amount of tax you owe. For example, on your 2023 tax return, if the only credit you’re eligible for is a $500 Child and Dependent Care Credit, and the tax you owe is only $200—the $300 excess is nonrefundable. This means that the credit will eliminate the entire $200 of tax, but you don’t receive a tax refund for the remaining $300. For 2021, the Child and Dependent Care Credit is fully refundable so not only would you reduce your tax to $0, you would be eligible for a $300 refund.
Refundable tax credits
Refundable tax credits, on the other hand, are treated as payments of tax you made during the year. When the total of these credits is greater than the tax you owe, the IRS sends you a tax refund for the difference.
Your tax return form will list all refundable tax credits, such as the Earned Income Tax Credit, in the same section you report your tax payments.
When you claim the American Opportunity credit for education expenses, you use Form 8863 to calculate the refundable and nonrefundable portions.
Partially refundable tax credit
A partially refundable credit such as the American Opportunity Credit (AOC), provides for a portion of the credit to be refundable and a portion not available for refund. With the AOC, up to 40 percent of the credit is refundable and counted as a tax payment. When you claim this credit for education expenses, Form 8863 separately calculates the refundable and nonrefundable portions.
For example, if you calculate a $2,000 American Opportunity credit, a maximum of $800 may be reported as a refundable tax credit with the remaining $1,200 reported as a nonrefundable credit.
Putting it all together
To illustrate how these credits work, assume that your 2023 tax return reports $2,400 of tax before taking the Child and Dependent Care and American Opportunity credits used in the examples above. You first reduce the tax by the $1,700 of nonrefundable credits you claim ($500 for the Child and Dependent Care Credit, plus $1,200 for the American Opportunity Credit). This brings your tax bill down to $700 ($2,400 - $1,700). You then reduce the $700 by the $800 refundable portion of your American Opportunity credit. This not only eliminates the entire $700 of tax, but also gives you a $100 tax refund for the excess.
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