What is a Nonrefundable Tax Credit?

November, 21 2024 by Brittney D. Williams, EA 

Understanding the mechanics of a tax return can be frustrating. When filing your tax return, the goal is to only pay the amount of tax you owe. It’s a given that you’re supposed to report all income, list your qualified dependents, and enter any adjustments to income, such as qualified educator expenses or traditional IRA deductions. But what else is there to do to get to the bottom line? What if the bottom line is a tax liability that you can’t afford to pay? Well, there are many available credits that taxpayers may claim to reduce their tax liability and still arrive at the correct amount of tax owed. Let’s dive into the discussion.
 

What is a tax credit?

A tax deduction is the same as a tax credit, right? You may often hear conversations where these words are used interchangeably. However, the answer is no. There is a distinct difference between a tax deduction and a tax credit. Tax deductions, such as the standard deduction, reduce the amount of a taxpayer’s income that is subject to tax. However, a tax credit, such as the Child Tax Credit, reduces a taxpayer’s tax liability. A tax credit reduces the amount of tax owed dollar-for-dollar.

There are two categories of tax credits for individual taxpayers: business credits for sole proprietors and farmers, and personal tax credits. Taxpayers engaged in a trade or business or an activity for the production of income are eligible to claim certain business credits. Keep in mind these business credits are for businesses that are not incorporated, such as sole proprietors, Single Member LLCs, certain rental properties, and farms. An example of a business credit eligible to be claimed by an individual taxpayer on Form 1040 is the General Business Credit. Personal tax credits are available to any qualified individual – you don’t need to be engaged in a business or profit-seeking activity. We will focus on personal tax credits that are not related to a trade or business.

Types of Tax Credits

Now that we know what a tax credit is, we can discuss the two types of tax credits: nonrefundable and refundable.

A refundable credit can generate or increase a taxpayer’s refund. If a taxpayer’s tax liability is less than the amount of a refundable credit, the difference is refunded to the taxpayer. The remainder of our discussion will focus on nonrefundable credits.

Alternatively, a nonrefundable tax credit is claimed before withholding and estimated tax payments are taken into consideration. It lowers your tax liability but not below zero. Therefore, a nonrefundable tax credit cannot be used to create a tax refund. However, if the taxpayer has withholding and/or estimated tax payments, these will be refunded. A nonrefundable tax credit also will not increase a tax refund. If there is an amount of unused nonrefundable tax credit(s) remaining after reducing your tax liability to zero, depending on the credit, you may be entitled to carry over the excess nonrefundable credit to other tax years.

Commonly Claimed Nonrefundable Tax Credits

Child and Dependent Care Expenses Credit – This is a credit for a portion of qualifying expenses paid for child or dependent care so a taxpayer may be able to work or look for work.

Child Tax Credit – A $2,000 credit for each qualifying child under the age of 17 and a $500 other dependent credit for a dependent that’s not a qualifying child. This credit should not be confused with the Additional Child Tax Credit that allows taxpayers to claim a disallowed portion of the nonrefundable Child Tax Credit after their tax liability had been reduced to zero.

• American Opportunity Tax Credit – Provides a maximum credit of $2,500 per eligible student for qualified education expenses paid. The majority of this credit is nonrefundable; however, 40 percent of the credit that exceeds the taxpayer’s regular tax and alternative minimum tax liability can be claimed as a refund. This credit can be claimed for four years per student.
   
• Lifetime Learning Credit – A credit that is equal to 20 percent of up to $10,000 of qualified education expenses paid. Unlike the American Opportunity Tax Credit, the maximum credit is $2,000 per return, not per student.

Adoption Credit – Provides a nonrefundable credit for qualified adoption expenses paid to adopt an eligible child.

Foreign Tax Credit – A credit permitting a U.S. taxpayer to offset income taxes paid to foreign countries or U.S. possessions. Claiming this credit allows taxpayers to reduce their tax liability and avoid double taxation on the same income earned internationally.

The Child Tax Credit is likely the most common nonrefundable tax credit used by individuals with children. As previously stated, the amount of the credit is $2,000 per qualifying child, which is a considerable tax savings. Let’s look at some examples of how this credit works.

Example 1:

Julia is a single taxpayer with two qualifying children. Her tax liability before applying any credits is $10,500. Julia’s tax liability after applying the Child Tax Credit is as follows:

$2000 x 2 = $4,000 available Child Tax Credit

$10,500 - $4,000 = $6,500 adjusted tax liability

Example 2:

What if Julia’s tax liability before credits is $2,500? The outcome is a bit different. Julia’s tax liability after applying the Child Tax Credit is zero, computed as follows:

$2,000 x 2 = $4,000 available Child Tax Credit

$2,500 - $2,500 (applicable Child Tax Credit) = 0 tax liability

In this example, Julia’s tax liability is less than the available Child Tax Credit. Therefore, she can only claim up to the amount of her tax liability before applying the credit. However, Julia may be able to claim all or a portion of the remaining amount as an Additional Child Tax Credit, which is a refundable credit on another section of the tax return.

Requirements to qualify for nonrefundable credits

To qualify for nonrefundable tax credits, certain requirements must be met. Each credit has its own specific qualifications, but they generally include one or more of the following:

• Who is considered a qualifying child – Certain criteria must be met, such as age, relationship, and residency.
• Earned Income – Some credits have earned income requirements and/or earned income limitations.
• Filing Status – Eligibility to claim certain credits can be affected by filing status.
• Income Limits – Some credits are limited or phased out completely if adjusted gross income (AGI) exceeds a certain limit.

Before claiming a tax credit, it is important to review the requirements and ensure that you meet the qualifications. You also want to maintain the necessary documentation to support the credit(s) claimed. Therefore, if the IRS chooses to audit your tax return, with proper documentation, you can avoid additional tax, penalties, and interest.

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