Tax credits are subtracted from the tax liability you calculate on your tax return, so they reduce the amount you owe on your taxes dollar-for-dollar. If you have a refundable tax credit, you can actually get more back from the IRS than you paid in estimated and payroll taxes. Nonrefundable tax credits are limited to the amount of your tax liability.
Limits on Nonrefundable Credits
The majority of tax credits are nonrefundable. When a nonrefundable credit is more than your tax liability, you don’t get the entire credit amount. Suppose you calculate a tax liability of $1,800 and you qualify for a $2,500 tax credit. If it's a nonrefundable tax credit, you may only take your tax credit down to zero, so you would subtract only $1,800. In most cases you lose the remaining $700 -- it's "use it or lose it." The Lifetime Learning Credit and Adoption Tax Credit are this type of credit.
With some nonrefundable credits, such as the Foreign Tax Credit and General Business Tax Credit, you can carry unused amounts forward to future tax years. There are time limits. For example, the carryforward limit for the Foreign Tax Credit is five years. For the General Business Tax Credit, unused amounts may be carried forward as much as 20 years.
The difference between refundable and nonrefundable tax credits is that you get the entire refundable credit amount even when you end up with a negative tax liability. For example, if a refundable tax credit is for $2,500 and your tax liability is $1,800, you will receive the $700 in the form of a refund. Examples of refundable tax credits are the Earned Income Tax Credit and the Additional Child Tax Credit.
Partially Refundable Tax Credits
Occasionally, Congress authorizes a partially refundable tax credit. For example, the American Opportunity Credit is a partially refundable tax credit used to offset undergraduate college costs. Parents of dependent students or students not claimed as dependents may qualify. Up to 40 percent of the $2,500 credit is refundable. The American Opportunity Credit is due to expire after 2012, however, unless Congress acts to renew it.