What Is a Non-Refundable Tax Credit?
A non-refundable tax credit is a tax credit that can only reduce a taxpayer’s liability to zero. Any amount that remains from the credit is automatically forfeited by the taxpayer. A nonrefundable credit can also be referred to as a wastable tax credit, which may be contrasted with refundable tax credits.
- A non-refundable tax credit is a type of income tax break that reduces one's taxable income dollar for dollar.
- A non-refundable tax credit can only reduce taxable income down to zero and will not generate a tax refund in the case that the potential credit exceeds the taxable income (as a refundable credit would).
- Examples in the U.S. include the foreign tax credit, the mortgage interest credit, and child or dependent care, among others.
How Non-Refundable Tax Credits Work
The government provides certain tax breaks in the form of tax credits to reduce the tax liability of its taxpayers. A tax credit is applied to the amount of tax owed by the taxpayer after all deductions are made from his or her taxable income, and this credit reduces the total tax bill of an individual dollar to dollar. If an individual owes $3,000 to the government and is eligible for a $1,100 tax credit, he will only have to pay $1,900 after the credit is applied.
Tax credits are more favorable than tax deductions or exemptions because tax credits reduce tax liability dollar for dollar. While a deduction or exemption still reduces the final tax liability, they only do so within an individual’s marginal tax rate. For example, an individual in a 22% tax bracket would save $0.22 for every marginal tax dollar deducted. However, a credit would reduce the tax liability by the full $1.
Tax Deductions Vs. Tax Credits
A tax credit can be either refundable or non-refundable. A refundable tax credit usually results in a refund check if the tax credit is more than the individual’s total tax liability. A taxpayer who applies a $3,400 tax credit to his $3,000 tax bill will have his bill reduced to zero, and the remaining portion of the credit, that is $400, refunded to him.
On the other hand, a non-refundable tax credit does not result in a refund to the taxpayer as it will only reduce the tax owed to zero. Following the example above, if the $3,400 tax credit was non-refundable, the individual will owe nothing to the government, but will also forfeit the amount of $400 that remains after the credit is applied.
Unlike a tax deduction, a tax credit reduces the amount of taxes that you owe, dollar for dollar.
Examples of Non-Refundable Tax Credits
The most commonly claimed tax credits are non-refundable. Examples include:
- Saver's credit
- Lifetime learning credit (LLC)
- Adoption credit
- Child and dependent care 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 to holders of tax credit bonds
Some non-refundable tax credits, such as the general business credit and foreign tax credit, allow taxpayers to carry any unused amounts forward to future tax years. However, there are time limits applied to the carryover rules. For example, while unused portions of the GBC may be carried forward up to 20 years, an individual can only carry FTC unused amounts forward up to ten years.
Pros and Cons of Non-Refundable Credits
A taxpayer who has both refundable and non-refundable tax credits can maximize his total credit potential if he calculates his non-refundable credits before applying his qualified refundable credits. Non-refundable tax credits should be used first to minimize the taxes owed. Only after should the refundable tax credits be applied to reduce the minimized amount even further so that if it falls below zero, if the tax liability becomes negative, the individual will receive a refund check for the total amount below zero.
If he files his taxes in reverse order, he will use up all his refundable credit and the non-refundable will only reduce his tax owed to zero—nothing less.
Nonrefundable tax credits, however, can negatively impact low-income taxpayers, as they are often unable to use the entire amount of the credit. Nonrefundable tax credits are valid in the year of reporting only, expire after the return is filed, and may not be carried over to future years. As of the 2020 tax year, specific examples of nonrefundable tax credits include credits for adoption, the child and dependent care credit, and the saver's tax credit for funding retirement accounts.