Tuesday, February 17, 2009

What 'refundable tax credit' means

One provision in today's stimulus bill that's attracting lots of attention is the $8,000 refundable tax credit for first-time homebuyers who purchase in 2009. But what does "refundable" actually mean? The confusion runs deep. Since most of us are doing our taxes right about now, it seems like a good time for a rundown on the often-slippery distinction between credits and deductions.

Here, in ascending order of usefulness, are the various ways the IRS lets you adjust your tax bill:

Tax deduction: Most items you "write off" on your taxes are deductions, which reduce the amount of your income that the IRS considers taxable. The actual cash you save depends on what tax bracket you fall into. A single person with $40,000 in income would, for 2008, fall into the 25% tax bracket and owe $4,981 in federal taxes for the year (saith Bankrate's tax calculator). But add a $1,000 deduction, and the tax drops to $4,731 -- $250, or 25% of the $1,000 that's been deducted.

Most deductions require you to itemize your return -- and about two-thirds of American tax filers don't itemize. Itemizing is only worth it if your deductions will exceed the standard deduction. Unless you have a mortgage, extremely high medical bills, or other major expenses, the standard deduction is a better deal.

I didn't expect to itemize my return until we eventually had a mortgage, but I was surprised two years ago when my tax software spat out an itemized return. One of the things you can deduct is state and local taxes, and in NYC, those get whomping -- they finally overwhelmed the standard deduction David and I would otherwise take. If you do venture into Itemizationland, it pays off to start tracking deductible things like charitable contributions and unreimbursed business expenses.

Adjustments to income: A handful of deductions are available even to those who don't itemize their returns -- which is a great deal, especially for students, at whom many of these deductions are aimed. Two common ones: You can deduct tuition expenses and student loan interest (subject to income caps).

Often called "above the line" deductions, these adjustments work out mathematically just like itemized deductions. For a single filer with income of $40,000, a $1,000 income adjustment will lead to a $250 savings.

Nonrefundable tax credits: A tax credit is better than a deduction. Instead of adjusting your income, a credit adjusts your actual tax bill, dollar-for-dollar. Mostly aimed at students and low-income filers, credits are powerful weapons that can take your tax liability all the way down to $0.

One popular tax credit is the Lifetime Learning Credit, which lets you deduct 20% of your educational expenses. If you had income of $40,000, a $4,981 tax bill, and a $1,000 Lifetime Learning Credit (for $5,000 in eligible expenses), you'd get to shave $1,000 straight off your tax bill, cutting it to $3,981.

Nonrefundable credits are only useful to those who make enough to owe tax. If you had income of just $4,000 instead of $40,000, you'd have earned less than the standard deduction and you'd owe no tax. If you also had tuition expenses, you wouldn't get any extra tax benefit -- you already owe nothing, so there's no tax bill for you to deduct them from.

Refundable tax credits: If credits are "powerful" weapons, refundable credits are nukes. These rare beasties can take your tax bill below $0 -- instead of you owing the IRS, Uncle Sam owes you.

One of the most common refundable tax credits is the Earned Income Credit, which works to boost income for low-wage workers by offering tax breaks. The credit will reduce your tax bill, but if it reduces it past $0, you still get the cash.

That's why the $8,000 homebuyer credit in the economic recovery act will have such a profound effect on the tax bills of those who qualify. That single person with $40,000 in income and a $4,981 tax bill -- add in an $8,000 homebuyer credit and their tax bill drops to -$3,019, meaning there's a nice check on the way. If, like most of us, you've already made tax payments through payroll withholding or other methods, you'll get what you're owed on the credit plus a full refund of what you've already paid.

The Finance Buff has a good explanation of how refundable-versus-nonrefundable credits work, and a list of various credits and which category they fall into.

Now, having written all that up, I'll go stare forlornly at my 2009 tax filing, which has none of those nice credits and deductions I got to play with in past years. Still, since it netted me a nice refund check that arrived a few days ago, I can't whinge too much.