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.