When I first came across the term “refundable tax credit,” I have to admit I was confused about its meaning. And now that the economic stimulus bill has been signed into law, and as other refundable credits have made the news, I’ve seen that my misconception is shared by others.
A tax credit is a dollar amount that decreases the amount of tax you owe. Normally, a tax credit stops once you reach zero tax liability. However, a refundable tax credit can cause your tax liability to cross over zero, resulting in a refund. This is what is meant by “refundable.” Therefore, even if you owe no tax or had no income, a refundable tax credit might result in receiving a check from the government. In effect, there is a possibility that some people, due to refundable tax credits, may find themselves with an “negative effective income tax rate,” receiving more from the government than they put into the system.
“Refundable” does not mean that you have to pay the credit back to the government over time. Depending on the tax credit, this may be the case, but you wouldn’t be able to tell just by virtue of it being called a refundable tax credit. An example of a refundable tax credit is the Earned Income Tax Credit, designed to reduce or eliminate tax paid by low-income workers.
Refundable tax credits create the possibility for scenarios in which certain families pay no income tax and still receive a payment from the government.
Updated September 8, 2016 and originally published February 17, 2009.