What is a Refundable Tax Credit?

Adam Hill

There are many tax credits available to U.S. taxpayers, depending on current tax laws that establish eligibility. Some tax credits are refundable, which means that even if they bring a person’s tax liability to less than zero, that money will be refunded. A refundable tax credit, therefore, can have the effect of returning more money to a taxpayer than he contributed into the tax system in a given tax year. Examples of refundable tax credits in the United States include the earned income tax credit and the additional child tax credit.

Tax credits are considered more valuable than tax deductions because credits directly reduce the taxes owed.
Tax credits are considered more valuable than tax deductions because credits directly reduce the taxes owed.

All tax credits, like tax deductions, reduce the amount of taxes owed. Tax credits are considered to be more valuable in general than tax deductions, because they directly reduce the taxes owed, rather than reducing the amount of taxable income, which has a much more indirect and diluted effect. For example, a person who owes $10,000 U.S. Dollars (USD) in taxes, who claims a $1,000 USD tax credit, has a tax liability of $9,000 USD. However, a tax deduction of a given amount only reduces the tax liability by that amount multiplied by the person’s tax bracket. If the person in the above example is in a 25% tax bracket, a $1,000 USD tax deduction will only reduce his tax liability by $250 USD, to $9,750 USD.

A refundable tax credit has the most potential worth in dollars and cents, though, because it takes full effect, regardless of whether a person owes taxes or not. Because refundable tax credits can result in a net payment from the treasury to a taxpayer, they enjoy understandable popularity, even though they have also been a subject of political controversy. Those with a fiscally conservative or libertarian view often criticize the idea of the refundable tax credit, seeing it as a subsidy or welfare payment in disguise. Those with opposing viewpoints often cite the benefits that refundable tax credits can have for working families and a nation’s economy at large.

Perhaps the best-known refundable tax credit in the U.S. is the earned income credit or EIC. The EIC was first enacted in 1975, and had at the time a very modest impact. It has, however, been expanded since that time, and can result in a tax credit of thousands of U.S. Dollars for one household, depending on the number of children a couple has. The exact definition of the EIC can change with the tax laws but in general, couples with more children are eligible for a higher tax credit.

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