Refundable vs. Non-Refundable Income Tax Credits

Written by Nickel - 10 Comments

Over the past week or so, I’ve heard from several readers who are somewhat confused about refundable vs. non-refundable tax credits and, ultimately, what it means to “pay taxes.” As a quick reminder, tax credits directly reduce your tax liability on a dollar-for-dollar basis. In contrast, tax deductions reduce your taxable income (and thus result in a fractional decrease of your tax liability).

Getting a Refund vs. Not Owing Taxes

Before we talk about refundable vs. non-refundable tax credits, we first need to talk about what it means to have a zero tax liability. This is likely old news to many of you, but… Just because you get a income tax refund does not mean that you haven’t paid any taxes. In fact, the tax money that is withheld from each of your paychecks is essentially a pre-payment of your total tax bill.

If more is withheld than you ultimately end up owing, you get a refund. Conversely, if you owe more than was withheld, you have to send in additional funds with your tax return (and you might also have to pay a penalty). Your total tax liability can be found on line 11 of IRS Form 1040EZ, line 37 of IRS Form 1040A, or line 61 of IRS Form 1040. If this number is greater than zero, then you’ve paid taxes whether or not you get a refund.

Refundable vs. Non-Refundable Tax Credits

Now that we’re all on the same page, we can turn out attention to tax credits… As noted above, there are two general categories of tax credits: refundable and non-refundable. The vast majority of tax credits are non-refundable, in that they can reduce your tax liability to zero, but not below. In contrast, a refundable tax credit can reduce your tax liability below zero. As such, refundable tax credits can be more properly viewed as a payment — you’ll still get it even if you don’t owe any taxes.

Much of the recent confusion surrounding refundable vs. non-refundable tax credits has been generated by all of the talk about homebuyer tax credits. The original $7500 tax credit for first-time homebuyers is a refundable credit. However, the fact that it’s supposed to be recaptured of the following 15 years makes it more of an interest-free loan than a credit. In contrast, the proposed $15,000 homebuyer tax credit is a non-refundable credit. Note that the “first-time homebuyer” language has been stricken from this version, and it also won’t need to be paid back.

Published on February 12th, 2009 - 10 Comments
Filed under: Taxes
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About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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Comments (scroll down to add your own):

  1. It should be illegal for them to call it a tax credit. If you have to pay it back, IT IS CALLED A LOAN!

    Comment by thomas — Feb 12th 2009 @ 12:01 pm

  2. I feel a little cheated i qualified for the $7500 tax credit but then weeks later another tax credit is approved for $500 dollars more an does not have to be repaid.

    Comment by tracy — Feb 14th 2009 @ 2:31 pm

  3. At least you have the option to use the credit. I bought my home 3 months to early, so consider yourself lucky:)

    Comment by SP — Feb 15th 2009 @ 4:25 pm

  4. I keep reading all sorts of different versions of and interpretations of these refundable tax credits, and I’m hoping fivecent nickel can put this one to rest like usual.

    I qualify for the $8000 first time homebuyer tax credit. I plan on applying this to my 2008 taxes. I came up with 2 obvious scenarios. I owe the Govt or I get a refund. I’ll say my Federal Tax liability is $6,000 for the year.

    Scenario 1: I have $5,500 in taxes withheld from my paycheck by my employer (thus, I would owe $500). I apply the $8,000 tax credit and now I receive a $7,500 refund.

    Scenario 2: I have $6,600 in taxes withheld from my paycheck from my employer (thus, I would get a $600 refund). I apply the $8,000 tax credit and now my refund is $8,600.

    Is this correct logic? A CNN article explained the 2nd scenario as I would only be getting an $8,000 refund instead of $8,600. How could that be? The Tax credit would only then be basically worth $7,400 just because my employer withheld more money in scenario 2 as compared to 1. Or, is the CNN Writer just incorrect?

    Thanks in advance.

    Comment by brad — Feb 16th 2009 @ 10:12 pm

  5. brad: Your logic sounds correct. An $8k refundable credit should turn that $6k tax liability into a -$2k liability (in other words, a $2k net gain for you). Thus, you should get back everything you paid in plus $2k. I just dug around on CNN and found something similar to what you describe, and it looks like the author is incorrect. Keep in mind that I’m not a tax pro, but I am pretty good at math. ;)

    Comment by nickel — Feb 16th 2009 @ 10:30 pm

  6. Brad – I saw the same article on CNN Money (http://money.cnn.com/2009/02/1.....tm?cnn=yes) and I had to laugh.

    If it worked the way CNN suggests, it would penalize people who withheld a lot in taxes. Let’s say you and I both have 10K in tax liability. You have 10K withheld ($0 refund), and I have 17,995 withheld (i.e. a $7995 refund).

    Under CNN Money’s scheme, we would both get a 8K refund … $8000 in “new money” for you and $5 in “new money” for me … in spite of the fact that our tax situation (aside from withholding) is identical. Essentially, I gave the government an interest-free loan during the year, and I would be penalized for it. Huh?

    I have had a couple of tax classes (I was an accounting major in college) and I would be shocked to see something this crazy implemented.

    It’s safe to say that CNN Money is just wrong. Very disturbing to see a mistake of that magnitude …

    Comment by kosmo — Feb 17th 2009 @ 11:49 am

  7. I saw this same article and doubted their math as well (eventually leading me to this blog). Brad, your examples look correct, I too think CNN messed up.

    Looking back at the article it appears they’ve corrected the scenarios, but not the “answer.” It should now read:

    “The short answer? Yes, Billings would get back the $8,000 plus what he’d overpaid. The long answer? Yes.”

    Comment by Justin — Feb 17th 2009 @ 3:42 pm

  8. So if I got a 3500 refund for 2008, and bought a house and qualified, I would get the 8,000 on top of my usual 3,500? This seems to good to be true?

    Comment by Sara — Feb 20th 2009 @ 9:28 am

  9. Okay after reading all of this I have a huge question. I bought my house on Jan 16th, 2009. I already filed my taxes back in january when the credit was 7500 and had to be repaid over 15 years. Now I am hearing that it is 8000 and does NOT need to be repaid. Am i stuck repaying my original plan or am i not obligated to pay that back now? So very confused, please help. Thanks.

    -Corey

    Comment by Corey — Feb 24th 2009 @ 3:58 pm

  10. My sister-in-law just bought a house for about $50,000. She only makes about $35,000/year. Would she still get 10% of the value as a refund, or would she get the whole 8,000 due to her low incom?

    Comment by Bill — Jul 21st 2009 @ 6:16 pm

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