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Your client has a $2,000 tax liability and a $3,000 refundable tax credit. How much of a tax refund will they receive?
- $0
- $1,000
- $2,000
- $3,000
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Correct answer: B. $1,000
Instructor insight:
A tax credit reduces your tax liability dollar for dollar, while a tax deduction only reduces your taxable income. This means a tax credit is much more valuable than a tax deduction of the same amount.
For example, a $1,000 tax credit directly reduces a person's tax bill by $1,000. The most a $1,000 tax deduction can reduce a person's tax bill is by $370 and this requires that the person is in the 37% tax bracket ($1,000 x 37% = $370). If the person is in a lower tax bracket the reduction will be even less.
The best part about refundable tax credits is that they can refund you above and beyond your tax liability. This enables individuals to receive a tax refund even if they did not overpay their taxes.
If instead the client had a nonrefundable tax credit of $3,000 the answer would be A. $0. This is because nonrefundable tax credits can only offset your tax liability. They do not refund you the excess credit amount above your tax liability.
Refundable tax credits are quite rare. Most credits are nonrefundable.
CFP® Exam insight: Test takers should be aware of is the American Opportunity Tax Credit which is a partially refundable credit. This credit commonly comes up on the Exam.
