Keeping the amount of taxes you owe as low as possible is just good financial sense. When you take advantage of tax deductions and tax credits, you may be able to reduce your tax liability to zero, meaning you don’t owe any federal income tax for the year. In some situations, you might even have tax credits that result in a negative tax liability.
Only certain tax credits, known as refundable tax credits, can actually result in negative tax liability for you.
When Tax Credits Can Mean Negative Tax Liability
A tax liability is the amount of money you actually owe in taxes after allowing for tax deductions and tax credits. Tax liability is what you owe before deducting prepaid amounts, such as estimated tax payments or taxes withheld from your paychecks. Prepayments are deducted after you calculate your tax liability on your tax return to determine if you still owe money or are entitled to a refund.
A tax deduction works differently than a tax credit. Deductions reduce the amount of your income subject to income taxes. A tax credit is a sum that is subtracted from your tax liability. Suppose your highest tax rate is 25 percent and you take a tax deduction for $1,000. Since you now have $1,000 less taxable income, you save $250. However, if you have a tax credit for $1,000 the entire amount is taken off your tax liability, meaning you save $1,000. The best you can do with tax deductions is to reduce your taxable income enough so that your tax liability is zero. However, some tax credits can result in a negative tax liability, meaning you actually receive money from the government (and the government receives negative tax revenue from you).
You have to use IRS Form 1040 to claim tax credits, including the Earned Income Tax Credit. After calculating your income, you subtract all of the tax deductions you are entitled to. Next, you calculate the tax you owe. This is your tax liability before you subtract any tax credits.
There are two kinds of tax credits: refundable and nonrefundable. If a tax credit is nonrefundable, you only get to subtract the amount of your tax liability or the amount of the tax credit, whichever is less. However, if the tax credit is refundable, you subtract the entire amount of the credit. This can produce a negative tax liability. For example, if your tax liability after deductions works out to $1,500 and you can claim a refundable tax credit for $2,000, you have a negative tax liability of $500. The IRS adds the $500 to any prepaid taxes when figuring your tax refund.
Refundable tax credits include the Earned Income Tax Credit, Health Coverage Tax Credit and the American Opportunity Tax Credit for college expenses. Examples of nonrefundable credits are the Child and Dependent Care Credit, Child Tax Credit and Residential Energy Tax Credit.
Some economists have proposed the idea for a negative income tax, where people making too little money to be eligible for income tax would instead receive money based on how little they make.
Partially Refundable Credits and Limits on Refundability
Certain refundable tax credits are only partially refundable. Partially refundable means if using the credit results in a negative tax liability, the negative amount is limited to a percentage of the total tax credit.
Examples include the Child Tax Credit, designed to help with the expenses of raising children, and the American Opportunity Tax Credit for college students. For example, the American Opportunity Tax Credit can deliver $2,500 in tax savings but only $1,000 is eligible for refund.
Refundable tax credits often have complex rules about eligibility and how much is refundable, so it's important to make sure you understand the rules before filing for these credits.
2018 Tax Law Changes
Amounts of tax credits and deductions often change slightly from year to year, but the 2018 tax year is bringing more changes than usual.
Among them is a shift in the Child Tax Credit, which is now worth $2,000 per eligible child. Of that, up to $1,400 is refundable per child, but that amount is limited to 15 percent of your taxable income above the first $4,500. The credit is also now available to wealthier households, including single people and heads of households making $240,000 or less, married couples filing jointly making $440,000 or less.
The expanded child tax credit is in part a replacement for personal exemptions, which taxpayers could previously claim for themselves and their dependents. Those no longer exist, though the standard deduction is now greater than the sum of the previous standard deduction and a taxpayer's own personal exemption.
2017 Tax Law Limits
Under 2017 tax law, the Child Tax Credit can deliver up to $1,000 per eligible child. The credit begins to phase out if your income as a single person or head of household is above $75,000 or above $110,000 for a married couple filing jointly.
Some of the Child Tax Credit is effectively refundable through what's called the Additional Child Tax Credit, generally limited to 15 percent of your earned income.
Taxpayers can also claim personal exemptions for themselves and their dependents under 2017 tax law, though these effectively function like deductions, reducing taxable income, rather than credits.
- Bankrate.com: Tax Credits: Cut Your Tax Bill
- 1040.com: Tax Credits
- Tax Policy Center: Refundable Credits: The Earned Income Tax Credit and the Child Tax Credit
- IRS: Health Coverage Tax Credit
- The Motley Fool: Your 2018 Guide to College Tuition Tax Breaks
- The New York Times: A $2,500 Tax Credit for Students Has a Few Pitfalls
- The Motley Fool: The 2018 Child Tax Credit Changes: What You Need to Know
- The Motley Fool: How the Child Tax Credit Can Help You
- IRS: Schedule EIC
Based in Atlanta, Georgia, W D Adkins has been writing professionally since 2008. He writes about business, personal finance and careers. Adkins holds master's degrees in history and sociology from Georgia State University. He became a member of the Society of Professional Journalists in 2009.