What Is a Refundable Tax Credit?

By Maurie Backman Markets Fool.com

Tax credits are a great way to lower your tax burden and put more money back in your pocket. A tax credit is a dollar-for-dollar reduction of the amount you owe in taxes. The IRS has a number of federal tax credits available to taxpayers, many of which are non-refundable. Some credits, however, such as the Earned Income Tax Credit, are refundable, which means that if they reduce your income tax liability to below zero, you'll still get a refund check for the difference. While any tax credit you're eligible for can reduce your taxes, it's especially important to go after refundable credits.

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How tax credits work

Tax credits work by directly reducing your tax liability. Tax deductions, by contrast, allow you to reduce the amount of your income that's subject to taxes. If you're eligible for a $2,000 tax deduction and make $50,000 a year, it means you'll only need to pay taxes on $48,000. But if your effective tax rate is 25%, that $2,000 deduction will only save you $500 in taxes. If you're able to apply a $2,000 tax credit to your return, you'll actually save that $2,000 in full.

Refundable versus non-refundable tax credits

There are two types of federal tax credits available to U.S. taxpayers: refundable and nonrefundable. Both ultimately serve the purpose of helping you lower the amount you owe in taxes, but when a credit is non-refundable, the most it can do is reduce your tax liability to $0. Refundable credits, on the other hand, offer you a chance to actually get money back from the IRS when you don't owe any taxes.

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Let's say you owe $1,000 in taxes before applying a tax credit of $2,000. If that credit is non-refundable, you'll end up wiping out what you owe, but you won't get a check for the difference. However, if that credit is refundable, you'll get a refund of $1,000.

Current examples of refundable tax credits

Though the rules regarding tax credits are subject to change, there are several tax credits that are currently refundable to filers who qualify. One such credit is the Earned Income Tax Credit, or EITC, which is designed for low-income families. If you meet all of the eligibility requirements, you could receive up to $6,318 for 2017 thanks to the Earned Income Tax Credit.

Another tax credit that's currently refundable is the American Opportunity Tax Credit. Designed to help families paying for higher education, the American Opportunity Tax Credit could pay you up to $2,500 for each qualified student in your household. Though the credit isn't fully refundable, it is partially refundable up to $1,000.

Of course, the IRS doesn't like to just give away tax credits, so qualifying for one isn't always easy. Typically, your income will need to fall below a certain threshold to be eligible for a tax credit. Also, don't assume that if you were eligible for a certain credit one year, you'll automatically get it the following year. On the flip side, it could be the case that you didn't qualify for a credit last year, but are eligible this year because of a change in income, dependents, or even tax law, which can be modified from one year to the next. Tax credits, especially refundable ones, can put a lot of money back in your pocket, so it pays to read up on them and take advantage whenever possible.

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