Taxpayers often encounter nonrefundable tax credits while navigating the complex world of income taxes. Unlike refundable tax credits, nonrefundable credits can only reduce your tax liability to zero without offering any refunds. In this article, we’ll explore how nonrefundable tax credits work, their differences from refundable credits, and provide examples of these credits in the U.S. tax code. We’ll also delve into strategies for maximizing nonrefundable credits and answer common questions about how they impact your tax returns.
What is a nonrefundable tax credit?
A nonrefundable tax credit is a reduction in the amount of income taxes that a taxpayer owes. It can reduce the amount owed to zero, but no further. In other words, the taxpayer forfeits any credit that exceeds the total amount of taxes owed.
By contrast, a refundable tax credit results in a refund from the Internal Revenue Service (IRS) if the credit reduces the taxpayer’s liability to a number below zero.
Refundable and nonrefundable tax credits are both subtracted from the amount of taxes that a taxpayer owes. Tax deductions, on the other hand, are subtracted from the taxpayer’s taxable income. A tax credit is subtracted from the taxpayer’s tax liability after all other qualified deductions from taxable income have been accounted for.
How do nonrefundable tax credits work?
The tax system of the United States gives a variety of tax breaks in the form of tax credits, which decrease the tax liability of qualifying taxpayers.
A tax credit reduces the total tax bill of an individual dollar for dollar.
Refundable credits vs. nonrefundable credits
A tax credit can be classified as either refundable or nonrefundable. If the amount of a tax credit exceeds an individual’s total tax liability, a refundable tax credit leads to the issuance of a refund check.
For instance, a taxpayer who applies a $3,400 refundable tax credit to a $3,000 tax bill will have the amount lowered to zero and receive $400 back.
A nonrefundable tax credit does not generate a return for the taxpayer, as it serves to offset the tax liability to zero.
Based on the aforementioned scenario, if the $3,400 tax credit were nonrefundable, the individual would not owe any money to the government. However, they would lose the remaining $400 that is not utilized after the credit is applied.
Tax deductions vs. tax credits
A tax deduction reduces taxable income, but a tax credit reduces the amount of taxes owed on a dollar-for-dollar basis.
The taxpayer’s marginal tax rate determines which benefit is preferable. If a taxpayer is eligible for a $100 tax deduction and has a 30% marginal tax rate, the deduction will save the taxpayer $30. If the same individual is eligible for a 50% tax credit on a $100 purchase, the savings are $50. However, if the same individual files a tax return, crediting 20% of $100, the savings are only $20.
Unlike tax deductions, which reduce taxable income, a tax credit reduces the amount of tax that you owe, dollar for dollar.
Examples of nonrefundable tax credits
Nonrefundable tax breaks that are frequently claimed include:
- Saver’s credit
- Lifetime learning credit (LLC)
- Adoption credit
- Foreign tax credit (FTC)
- Mortgage interest tax credit
- Elderly and disabled credit
- Residential energy-efficient property credit
- General business credit (GBC)
- Alternative motor vehicle credit
- Credit for holders of tax credit bonds
Some nonrefundable tax credits, like the GBC and FTC, allow taxpayers to carry unused amounts back and forward. However, carryover rules include time constraints that vary each credit. Unused FTC payments can only be carried forward for 10 years, whereas GBC portions can be carried forward for 20 years.
Strategies for maximizing nonrefundable credits
If a taxpayer has both refundable and nonrefundable tax credits, the benefits can be maximized by applying the nonrefundable credits before claiming any refundable credits.
Nonrefundable tax credits should be used first to minimize the taxes owed. Only then should the refundable tax credits be applied to reduce the tax liability even further to the point that the liability reaches zero. If any refundable credits are unused after the total tax liability is completely offset, the taxpayer will receive a refund check for the total amount of unused credits.
If refundable credits are claimed first, all of them may be utilized to offset taxes, and any leftover nonrefundable credits may decrease the tax owed to zero. The unused nonrefundable credits will not entitle the taxpayer to a refund.
Low-income taxpayers are often unable to use the entire amount of their nonrefundable credits. Nonrefundable tax credits are valid only in the year when they are generated; they expire if unused and may not be carried over to future years. For the 2022 tax year, specific examples of nonrefundable tax credits include credits for adoption, credits for energy-efficient residential property, and the saver’s tax credit for funding retirement accounts.
What is the foreign tax credit?
The foreign tax credit (FTC) is a nonrefundable credit for U.S. taxpayers who have income overseas that minimizes double taxation. Since American citizens must pay U.S. income tax on all sources of income, domestic or foreign, the FTC offsets some of the foreign tax already paid on the same income.
Can I receive a tax refund if I use a nonrefundable tax credit?
Sure, you’ll still receive the refund that you qualify for, but it won’t include a reimbursement for any unused portion of your nonrefundable tax credit. It also depends on how much tax withholding you’ve had during the year. Nonrefundable credits decrease your tax payment but do not return you if your tax bill goes to zero and the credit is not used. However, if you had zero taxable income due to such credits and paid taxes monthly via payroll withholding, you may receive a refund.
What are examples of refundable tax credits?
Refundable tax credits are refunded to the taxpayer regardless of the taxpayer’s liability. These include the earned income tax credit (EITC) and the additional child tax credit (ACTC).
Here is a list of the benefits and drawbacks to consider.
- Nonrefundable tax credits can reduce your tax liability dollar for dollar.
- They are particularly beneficial for lower-income filers.
- Some nonrefundable credits allow carryovers to future tax years.
- If your tax liability is already low, you may not benefit much from nonrefundable credits.
- Unused nonrefundable credits cannot be carried over to future years.
- Understanding the complex tax code can be challenging.
The bottom line
Nonrefundable tax credits decrease a taxpayer’s bill to zero, but not further. Unused nonrefundable credits are not repaid if the taxpayer owes less than the credit is worth. Not so with refundable credits. Taxpayers with both types of credits should use nonrefundable credits first. Only then should they consider refundable credits.
Frequently asked questions
What is the difference between a refundable and nonrefundable tax credit?
Refundable tax credits decrease your tax liability below zero and result in a refund, while nonrefundable credits only reduce your tax liability to zero.
How can I maximize the benefits of nonrefundable tax credits?
If you have both refundable and nonrefundable tax credits, use the nonrefundable credits first to reduce your tax liability. Then, apply any refundable credits to further reduce your tax liability or potentially receive a refund.
Are nonrefundable tax credits the same every year?
No, the availability and terms of nonrefundable tax credits can change from year to year. It’s essential to stay updated with the latest tax laws and consult a tax professional for guidance.
- A fixed exchange rate ties a country’s official currency exchange rate to another currency or the price of gold.
- This system aims to keep a currency’s value stable within a narrow range.
- Fixed exchange rates provide certainty for international trade and help control inflation.
- However, they can limit a central bank’s ability to adjust interest rates and may lead to parallel unofficial exchange rates.
View article sources
- Earned Income Tax Credit (EITC) – Internal Revenue Service
- Tax Deductions and Credits List: Complete Guide for 2023 – SuperMoney
- Tax credit – Legal Information Institute
- Tax credit – Department of Revenue Canada