Refundable Credits: Understanding, Qualifying, and Pros & Cons

A refundable credit stands out in the realm of tax credits by assuring a refund to the taxpayer, regardless of their tax liability. Unlike non-refundable credits that only zero out the tax liability without any cash refund, refundable credits have the unique capability to generate a cash refund for the taxpayer, even if their liability goes into negative territory.

The nomenclature “refundable” originates from the unique feature that allows taxpayers to receive payments from the U.S. government, facilitated by the IRS, in case the credit results in a negative tax liability. This sets them apart from non-refundable credits, which can only reduce the taxpayer’s liability to zero without any accompanying refund.1

A taxpayer can claim a refundable credit that exceeds their tax liability, and the IRS will issue the balance as a refund. Unlike non-refundable tax credits, refundable credits have the flexibility to take a liability balance below zero, making them applicable to taxpayers with no tax liability. It is advisable for taxpayers to meticulously calculate all paid taxes, deductions, and non-refundable credits before applying any refundable credits.

Both non-refundable and refundable tax credits come with specific eligibility criteria, including income level, family size, occupation type, investment or savings type, earned income, and other situational factors. Credits may take the form of fixed amounts, percentages of income or tax liability, or follow a step scale where lower-income taxpayers receive a larger credit than those with higher incomes.

Certain taxes, such as the self-employment tax and tax on premature distributions from retirement accounts, cannot be offset by non-refundable credits. Specific refundable credits are designed to address these particular tax scenarios. For instance, the earned income credit is a refundable credit that can offset taxes not covered by non-refundable credits.4

A refundable credit guarantees a cash refund to the taxpayer, even if their tax liability goes below zero. In contrast, a non-refundable credit only reduces the taxpayer’s liability to zero without providing any refund.

Yes, a taxpayer can claim a refundable credit exceeding their tax liability, and the IRS will issue the balance as a refund.

No, a taxpayer with no tax liability cannot use a non-refundable tax credit as it cannot take a liability balance below zero.

Yes, certain taxes like self-employment tax and tax on premature distributions from retirement accounts can only be offset by certain refundable credits.