Tax credit is a coupon-like tool that taxpayers could use to subtract the taxes owed to their government, just like a gift card in taxpaying. There are three basic forms of tax credit, which are refundable, partially refundable, and nonrefundable tax credits.
- Nonrefundable tax credits
Nonrefundable tax credits will directly subtract the tax liability until the tax bill equals $0. Even if the amount of the credit is greater than the tax owed, the taxpayer will not get a tax refund. In other words, the remaining part of the nonrefundable tax credits that has not been used is lost. And thus this form of tax credits is called “nonrefundable”. Anyway, the taxpayer does not need to pay any extra tax.
Nonrefundable tax credits are only valid in the year of claiming, which will expire after the return is filed. Therefore, nonrefundable tax credits do not suit low-income taxpayers who are, for the most part, unable to utilize the entire amount. As of the 2019 tax year, nonrefundable tax credits include the Child and Dependent Care Credits, the Saver’s Tax Credits used to fund retirement, the credits for adoption, and the mortgage interest credits that cut the cost of housing for people with lower incomes.
- Partially refundable tax credits
Partially refundable tax credits can both reduce taxable income and decrease tax liability. Examples of partially refundable tax credits include Child Tax Credit, American Opportunity Tax Credit (AOTC) for post-secondary education students. If a taxpayer has reduced his tax due to $0 before using the entire amount of the tax deduction worth $2,500, the remainder may be taken as a refundable credit. The value is up to the lesser of 40% of the credit, or $1,000.
- Refundable tax credits
This form of tax credits is the most beneficial credit because the taxpayer not only gets the credits paid out in full but also receives a refund. Taxpayers with refundable tax credits, despite their income or tax liability, are eligible to the entire amount of credit. Once the tax liability is cut to below $0 by the refundable tax credits, the taxpayer could receive a refund.
Refundable tax credits include Earned Income Tax Credits (EIC) for people with low or moderate incomes and Premium Tax Credits that help people reduce the cost of premiums for health insurance.