Most taxpayers know that a tax credit reduces the amount of tax you pay the IRS. But some may not realize that there are two types of tax credits: standard credits and refundable credits. And there's a big difference between the two.
All tax credits directly reduce the tax you owe; in other words, every dollar of a credit takes a dollar off your tax bill. Note: Tax credits are not to be confused with tax deductions, which lower your taxes indirectly (and by a smaller amount) by reducing your taxable income.
The first type of tax credit is the standard credit, which can reduce your tax liability to $0 but not further. If the credit exceeds your tax liability, then the remainder of the credit is lost. A refundable credit can reduce your tax liability beyond $0, which means the IRS will have to pay the remainder to you as a refund.
Here's an example: If you owe $1,000 in taxes, and you have $3,000 in non-refundable credits, then you owe no tax, but the excess $2,000 in credits is lost. If you owe $1,000 in taxes and you have $3,000 in refundable credits, then your taxes will be reduced to zero, and you may be entitled to a $2,000 refund.
Here are three of the most lucrative and sometimes overlooked refundable credits.
1. The Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is a refundable credit for taxpayers who work but don't earn much. A full 20% of taxpayers who qualify don't claim it because they don't file a return, don't know about it, or feel it's too complicated to understand. It requires that the taxpayer fall within certain income and investment limits while meeting residency and filing status requirements. And those who are eligible can increase their credit if they have qualifying children. Did I mention you also must have earned income?
A quick review of the checklist provided by the IRS will help you determine whether you qualify for the EITC. For more details, you can review Publication 596. If you use tax preparation software such as TurboTax or TaxAct, then it will make the process relatively painless by asking all of the pertinent questions and making these determinations in the background. (And if you can use tax prep software, I would highly recommend doing so. It can help you avoid mistakes and get your refund faster if you're expecting one.)
If you don't think claiming the EITC is worth your time, consider this: The average amount of the EITC is more than $2,400, and the maximum is $6,318! If you think you're qualified but aren't sure how to proceed, then you can find a local tax professional to help. If the cost of a tax preparer is too high, the IRS provides the Free File service, which allows low-income taxpayers to use brand-name software at no cost.
2. Additional Child Tax Credit
While the Child Tax Credit is non-refundable, its sibling, the Additional Child Tax Credit, is. As with all credits, there are certain limitations. You must first be eligible, and file, for the Child Tax Credit, which is worth up to $1,000 for each qualifying child. If the amount of the Child Tax Credit is more than the amount of the tax you owe, then you may be eligible to receive all or part of the difference under the Additional Child Tax Credit. Be aware that those filing a 1040-EZ cannot claim this credit. You can find the Child Tax Credit Worksheet in the Instructions for Form 1040. If you qualify for the Child Tax Credit, you should fill out Form 8812 to determine your eligibility for the Additional Child Tax Credit. More details are available here.
3. American Opportunity Tax Credit
The American Opportunity Tax Credit is only partially refundable and provides incentives to go to college. Both the student and the education paid for must meet certain requirements. It's a credit for qualified expenses that go toward the first four years of higher education. It's worth up to a maximum of $2,500 per year per eligible student. It covers 100% of the first $2,000 in education expenses, then 25% of the next $2,000. Once your tax bill has been paid down to zero, you may receive a refund of up to 40% of the remaining amount up to $1,000. You can find the qualifications here.
There are many opportunities for taxpayers to minimize their taxes and maximize their refunds. We're not required to pay any more than is required. Take it from Justice Billings Learned Hand, who had this to say in an often-quoted tax case: "Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands."