Refundable versus Non-Refundable Tax Credits: The Crucial Difference

• Author: William Asher
• Posted: 2024-08-28

Even though the tax season has been extended due to COVID-19 issues, we'll all need to finally file taxes before the new deadline if we haven't already. Unfortunately, many Americans miss out on tax deductions due to simple lack of awareness. Lower-income Americans and those on Social Security or other fixed incomes are disproportionately affected by this.

Here's what you need to know about the many refundable and non-refundable tax credits offered by the IRS and what the key difference is.

The Main Difference

Each deduction offered by the IRS has either a "refundable" designation or a "non-refundable" designation. Many states that collect income tax have the same or similar verbiage in their tax laws.

Almost all deductions are "non-refundable" per IRS regulations. If a deduction is marked as "non-refundable", that means that you cannot reduce your tax liability below $0 with it. For example, if you only owe $200 in federal income tax but qualify for a $300 non-refundable deduction, you simply won't owe income tax. However, you won't receive a $100 check from the IRS for the remaining money.

On the other hand, "refundable" credits essentially guarantee that you'll receive the money one way or another. For example, let's say that you qualified for the Earned Income Tax Credit (EITC) and that you qualified for the full $538, the maximum for an adult with no children. In our example, your federal tax liability will be $100. In this case, not only would you pay no federal income taxes, but the IRS would pay you that remaining $400 via direct deposit or check.

Another key difference, especially important for those who are self-employed or must file a 1099 form at the end of each tax year, is that non-refundable tax credits cannot count towards "FICA" taxes. FICA is simply composed of Social Security and Medicare and is considered separate from standard federal income tax. Unfortunately, self-employed individuals must pay the so-called "Self-Employment Tax", meaning that they must pay both the employer and employee FICA taxes with a few exceptions. This makes non-refundable credits even less useful for these individuals. However, refundable tax credits are applied to FICA taxes, as well.

Commonly Claimed Credits

Here is an example of a refundable and a non-refundable tax credit. These two credits are on the list of the most commonly claimed due to their value and ease of claiming on tax forms.

The Earned Income Tax Credit (Refundable)

The EITC mentioned earlier is one of the most commonly claimed credits. It's intended to assist those who don't make much money. There's no adjustment for local cost of living, so it's the same for everyone in the country. The official amounts of the credit for 2020 have not been finalized. However, those with at least one child who make the qualifying income maximum or less could see a several thousand dollar refundable credit. Remember to claim this when filing, since the IRS does not automatically find applicable tax credits and apply them for you.

The Retirement Savings Tax Credit (Not Refundable)

Another commonly claimed tax credit has various names but is usually called the "Retirement Savings" credit. Though only 38% of American workers are aware of it according to a Bloomberg survey, this tax credit is designed to assist lower-income Americans with saving money. Like the EITC, the income thresholds depend on how many children one has and if he or she is married. However, this credit is not refundable.

The Retirement Savings credit is a bit difficult to understand at first. You should look up the IRS's rates for this credit, since they constantly change. First, they only apply to up to $2,000 of income for a single person or $4,000 for a married couple. Depending on how close your income is to the federal poverty line, you could qualify for one of the following "matching brackets": 50%, 20%, or 10%. This is the amount of tax credit the IRS gives you of any amount contributed to any retirement account.

For example, if you contributed $1,500 and were in the 50% bracket, you'd have that amount in your retirement account plus a non-refundable tax credit of $750 applied to your federal income tax, but not your FICA taxes. Notably, even the post-tax Roth IRA qualifies for this credit.

Wrapping Up

Many people are not familiar with tax credits and how they work. Knowing the common ones and the difference between ones that are refundable and not refundable is critical to your financial well-being.