Non-Refundable Tax Credit

A credit that is applied to taxes payable that only reduces a taxpayer’s liability to a minimum of zero

What is a Non-Refundable Tax Credit?

A non-refundable tax credit is a credit that is applied to taxes payable that only reduces a taxpayer’s liability to a minimum of zero. In other words, it cannot go below zero and cannot be refunded to the taxpayer. Any amount below zero for the tax credit is automatically forfeited by the taxpayer.

Non-Refundable Tax Credit

It is in contrast to refundable tax credits. Refundable credits are refunded to the taxpayer, even if their tax liability is below zero. They are favorable for taxpayers since they can actually be refunded cash.

Tax credits are classified based on tax laws as either refundable or non-refundable. Generally, the tax credits differ from year-to-year and between different tax regulators.

Tax Credits Explained

A tax credit is a sum of money that taxpayers are able to subtract from their tax liability. Tax liabilities are money owed to the government. Tax credits are different than tax deductions. Tax deductions reduce the amount of taxable income reported; however, tax credits are applied afterward to reduce the actual amount of tax payable.

Tax credits can be applied to taxable income for both individuals and corporations for various reasons related to locations, classifications, or industries.

Tax credits may be used to incentivize consumers to behave in a certain way. For example, governments providing electric vehicle (EV) tax credits to those who purchase EVs. It incentivizes consumers to purchase EVs that are carbon-neutral and better for the overall environment.

Tax credits can also be used to redistribute wealth and give tax breaks to low-income or otherwise disadvantaged individuals.

Common examples of tax credits in the U.S are as follows:

  • Earned Income Tax Credit – For employees
  • Child and Dependent Care Credit – For those taking care of a dependent
  • American Opportunity Tax Credit – For students pursuing higher education
  • Lifetime Learning Credit – For education expenses and job training
  • Advanced Premium Tax Credit – For helping low-income earners afford health insurance
  • Savers Credit – For low-income earners who contribute to retirement plans
  • Adoption Credit – For parents who adopt a child
  • Child Tax Credit – For those taking care of a child
  • Credit for the Elderly or the Disabled – For those above 65 or are permanently disabled

There are additional tax credits in other jurisdictions that are similar to the ones mentioned above.

Tax credits are generally better than deductions for the taxpayer since they reduce the tax liability directly, whereas deductions reduce tax payable and are deducted based on the taxpayer’s tax bracket.

Practical Example

For example, a tax deduction of $1,000.00 at a marginal tax rate of 25% would result in tax savings of only $250.00 ($1,000 x 25%). Whereas, a tax credit of $1,000 would result in tax savings of $1,000 directly.

Non-Refundable Tax Credits Explained

Non-refundable tax credits directly reduce tax liability but only up to the limit of $0. Any other further tax credits are lost. Non-refundable tax credits are generally only valid for the year of reporting and cannot be carried forward or backward to other years. It is to the detriment of low-income earners who lose their tax credits and cannot realize them in other years.

How Do Non-Refundable Tax Credits Function?

The government utilizes tax credits to provide certain tax breaks and reduce the liability of taxpayers. First, pre-tax net income, or earned income, is calculated by adding all sources of income that an individual earns in a tax year.

Then, deductions are applied to earned income to arrive at the taxable income figure. After the deductions, the tax credits are the last thing to be applied to the taxable income to arrive at the actual tax payable.

Practical Example

An individual receives $50,000 of employment income and $10,000 of other income from a rental property. The individual is entitled to tax deductions of $5,000 and non-refundable tax credits of $5,000. They are also subject to a marginal tax rate of 25%. What is their taxable income?

Taxable Income
Employment Income $50,000
Rental Income $10,000
Earned Income $60,000
Less: Deductions
Deductions $(5,000)
Marginal Tax Rate x 25% ($1,250)
Taxable Income   $58,750

Now, what is their tax payable?

Tax Payable
Taxable Income $58,750
Less: Tax Credits $(5,000)
Tax Payable   $53,750

Now, assume that instead of the non-refundable tax credit being $5,000, what if it was $60,000 instead? What is the tax payable?

Tax Payable
Taxable Income  $58,750
Less: Tax Credits $(58,750)*
Tax Payable   $0
*Can only reduce tax payable to 0

Related Readings

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