How do you know if a tax credit is refundable?

REFUNDABLE VERSUS NONREFUNDABLE TAX CREDITS

The maximum value of a nonrefundable tax credit is capped at a taxpayer’s tax liability. In contrast, taxpayers receive the full value of their refundable tax credits. The amount of a refundable tax credit that exceeds tax liability is refunded to taxpayers.

Most tax credits are nonrefundable. Notable exceptions include the fully refundable earned income tax credit (EITC), the premium tax credit for health insurance (PTC), the refundable portion of the child tax credit (CTC) known as the additional child tax credit (ACTC), and the partially refundable American opportunity tax credit (AOTC) for higher education. With the EITC, PTC, and ACTC, taxpayers calculate the value of these credits and receive the credit first as an offset to taxes owed, with any remainder paid out as a refund. With the AOTC, if the credit fully offsets taxes owed, 40 percent of the remainder can be paid out as a refund.

BUDGET TREATMENT OF REFUNDABLE VERSUS NONREFUNDABLE TAX CREDITS

The federal budget distinguishes between the portion of a tax credit that offsets tax liability and the portion that is refundable, classifying the latter as an outlay. Most of the EITC—an estimated $65.6 billion of the 2019 total of $68.3 billion—was refunded. Much less of the child tax credit ($40.1 billion out of $115 billion) was refunded (figure 1). The 2017 Tax Cuts and Jobs Act substantially changed the child tax credit for 2018 through 2025, including doubling the maximum credit to $2,000 per child under age 17 while limiting the maximum refund to $1,400 (this amount will increase with inflation up to $2,000.) The TCJA also created a nonrefundable credit worth $500 per dependent not qualifying for the full $2,000 credit. Before this change, expenditures on the child tax credit totaled $54.3 billion, with just over half delivered as refunds. In FY2019, expenditures from the CTC totaled an estimated $115 billion; of which 35 percent was refundable.

ADVANTAGES AND DISADVANTAGES OF REFUNDABLE CREDITS

Proponents of refundable credits argue that only by making credits refundable can the tax code effectively carry out desired social policy. This is especially true for the EITC and the CTC: if the credits were not refundable, low-income households most in need of assistance would not benefit from them. Furthermore, allowing credits only against income tax liability ignores the fact that most low-income families also incur payroll taxes.

Opponents of refundable credits, for their part, raise a host of objections:

• The tax system should collect taxes, not redistribute income.
• The government should not use the tax system to carry out social policies.
• Everyone should pay some tax as a responsibility of citizenship.
• Refundable credits increase administrative and compliance costs, and encourage fraud.

Updated May 2020

A refundable tax credit can be used to generate a federal tax refund larger than the amount of tax paid throughout the year. In other words, a refundable tax credit creates the possibility of a negative federal tax liability. An example of a refundable tax credit is the Earned Income Tax Credit.

How Does a Refundable Tax Credit Work?

An individual who qualifies for a refundable tax credit will receive a payment from the government in excess of the taxes they would otherwise owe. Instead of paying taxes, they are eligible to be net recipients.

For instance, let’s say an individual has a tax bill of $100, but is eligible for a refundable tax credit of $150. Instead of paying $100 in tax, the worker’s tax bill is reduced to negative $50, meaning they will receive $50 from the government. This is essentially a negative income tax.

What Are Some Examples of a Refundable Tax Credit?

In U.S. federal policy, the two main refundable tax credits are the Earned Income Tax Credit (EITC) and the Additional Child Tax Credit (ACTC). The EITC is targeted at low-income workers. The majority of those benefits accrue to people with an adjusted gross income (AGI) under $30,000, and about a third of benefits accrue to people with an AGI under $15,000.

The ACTC is a portion of the Child Tax Credit which is refundable. The maximum ACTC for 2020 is $1,400.

What Are the Reasons for Having a Refundable Tax Credit?

Refundable tax credits like the EITC and the ACTC create negative income taxes. This means that some earners get refunded by the tax system because of their family status, level of income, or some combination of both.

For those in favor of a progressive tax system, negative rates at the bottom of the income distribution help to ensure progressivity. Additionally, negative income taxes can help to offset the role that payroll taxes play in the tax burden of lower-income individuals.

Policymakers also may favor a refundable tax credit to create incentives for work, including shifts from unemployment to employment which may coincide with loss of unemployment benefits. A negative income tax can increase the return to working beyond an individual’s wages. However, refundable tax credits like the EITC are designed not only to incentivize work but, because the credit is limited by income, can also increase marginal tax rates as the benefits are reduced when individuals earn more.

Which tax credit is refundable?

Do tax credits get refunded?

Are all credits refundable?

What are refundable and nonrefundable tax credits?