A nonrefundable tax credit is a reduction in the amount of income taxes that a taxpayer owes. It can bring the owed amount down to zero, but not beyond. Essentially, any credit amount that exceeds the total tax liability gets forfeited.
In contrast, a refundable tax credit may result in a refund if it reduces the taxpayer’s liability below zero. Both refundable and nonrefundable tax credits are subtracted directly from the amount of taxes owed, while tax deductions are subtracted from the taxpayer’s taxable income. Generally, tax credits often lead to greater savings, especially for lower-income filers.
Key Insights
- Tax Credit Advantage: A tax credit reduces your tax liability dollar-for-dollar.
- Nonrefundable Credit: It can only reduce your tax liability to zero and no further.
- Refundable Credit: It can lead to a refund if it reduces your tax liability below zero.
- Examples: Common nonrefundable credits include the foreign tax credit and saver’s credit.
How Nonrefundable Tax Credits Work
The U.S. tax code offers various tax breaks in the form of tax credits that lower the tax burden for eligible taxpayers. Tax credits are applied to the tax owed after all permissible deductions from taxable income have been made. They directly reduce the total tax bill dollar-for-dollar.
Refundable Credits vs. Nonrefundable Credits
Tax credits can be refundable or nonrefundable. A refundable tax credit may result in a refund if it exceeds the taxpayer’s liability. For instance, a $3,400 refundable tax credit on a $3,000 tax bill will zero out the bill and return the remaining $400 to the taxpayer. However, a nonrefundable credit will only zero out the tax bill, and any excess credit will be forfeited.
Tax Deductions vs. Tax Credits
Tax deductions lower the taxable income, whereas tax credits reduce the tax owed, dollar-for-dollar. The benefit size depends on the taxpayer’s marginal tax rate. For example, a tax deduction of $100 with a 30% marginal tax rate saves the taxpayer $30. In contrast, a tax credit worth $100 offers benefits exactly worth $100, regardless of the marginal tax rate.
Examples of Nonrefundable Tax Credits
Frequently claimed nonrefundable credits 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 credits, like the general business credit (GBC) and foreign tax credit (FTC), allow unused amounts to be carried backward to a prior year or forward to future years, with specific time limits.
Strategies for Maximizing Nonrefundable Credits
If a taxpayer qualifies for both refundable and nonrefundable credits, applying the nonrefundable credits first can maximize benefits. This strategy ensures that any tax liability is minimized to zero before applying any refundable credits. Remaining refundable credits can then be issued as a refund.
For low-income taxpayers who can’t use the full amount of their nonrefundable credits within the year, it’s essential to note that these credits are only valid in the year they are generated and may not be carried over.
Nonrefundable Credits for the 2023 Tax Year
Specific nonrefundable tax credits for the 2023 tax year include adoption credits, credits for energy-efficient residential property, and the saver’s tax credit for retirement savings.
The Foreign Tax Credit: Minimizing Double Taxation
The foreign tax credit (FTC) allows U.S. taxpayers with income generated overseas to avoid double taxation. Since U.S. citizens must pay taxes on all income sources, the FTC offsets a portion of foreign taxes already paid on the same income.
Getting a Refund with Nonrefundable Tax Credits
Though you can get other forms of refunds, nonrefundable tax credits won’t reimburse any unused portions. However, if your tax liability hits zero due to such credits and you have paid taxes via payroll withholding, a refund might still be issued.
Examples of Refundable Tax Credits
Refundable tax credits are refunded to taxpayers even if their liability is below zero. Examples include the earned income tax credit (EITC) and the additional child tax credit (ACTC).
Final Thoughts
Nonrefundable tax credits can reduce tax bills only to zero. Any unused portion is forfeited. Conversely, refundable credits may lead to a tax refund. To maximize benefits, apply nonrefundable credits first, and then refundable credits.
Related Terms: refundable tax credit, income tax, tax liability, tax deductions.
References
- Internal Revenue Service. “Tax Credits for Individuals: What They Mean and How They Can Help Refunds”.
- Internal Revenue Service. “Schedule 3, Additional Credits and Payments”, Page 1.
- Internal Revenue Service. “Lifetime Learning Credit”.
- Internal Revenue Service. “Topic No. 856 Foreign Tax Credit”.
- Internal Revenue Service. “Instructions for Form 3800, General Business Credit”, Pages 1-2.
- Internal Revenue Service. “Foreign Tax Credit”.
- Internal Revenue Service. “Earned Income Tax Credit (EITC)”.
- Internal Revenue Service. “What You Need to Know About CTC, ACTC and ODC”.
