Kids aren't cheap. Between providing for their food, clothes, childcare, activities, toys, possibly college, and countless other things, the financial cost of raising children can be quite high. However, most parents will admit that the joys and wonders of having children far outweigh the financial costs (at least until their adolescent years). Luckily for those who have qualifying children, many will receive an expanded tax benefit in the form of a tax credit from the recently passed American Rescue Plan. This credit is in addition to the enhancements of the Child and Dependent Care Tax Credit that was discussed in a previous blog. Here's what you should know about the Child Tax Credit, and what expanded benefits may apply to you.
What is a Tax Credit?
Before we dive into the Child Tax Credit and why this may be some welcome relief for families, we first need to review what a tax credit is. A tax credit is a dollar-for-dollar reduction of your total tax due. Tax credits are more preferable than deductions because a deduction only reduces your taxes by your marginal tax rate.
Ex: Mike and Mary file a joint return, in 2020 their total tax due was$20,000, and they are in the 25% tax bracket. They have the option to either take a tax credit of $1,000 or a deduction of $2,000. If they take the credit, it will reduce their total tax due to $19,000 ($1,000 of total savings). If they take the deduction, their total savings is only $500 because they are in the 25% bracket even though the deduction was twice as much ($2,000 * 25% = $500). In this case, the tax credit is the better option.
It's also important to mention that there are two different types of credits, refundable and non-refundable. A non-refundable credit will only reduce your taxes down to $0. Any left-over credit is lost. With a refundable credit, if your tax liability is reduced to $0, any remaining credit is refunded back to you.
Ex: Jack and Dianne did not earn much income in 2021 and had a total tax liability of $2,000. They have the option to claim either a $2,500 refundable credit or a $5,000 non-refundable credit. If they choose to take the non-refundable credit their tax due would be reduced to $0 but the leftover $3,000 credit would be lost. If they take the refundable credit, they would receive the remaining $500 back in the form of a tax refund.
How Much is the Child Tax Credit?
Now that we've gone over how tax credits work, we can look at how much the Child Tax Credit is this year. Normally the credit is $2,000 per qualifying child. However, currently for 2021 only, the credit is increased to $3,000 for each qualifying child who 17 or younger (under age 18) and $3,600 for children under 6!
Who Qualifies for the Expanded Credit?
Unfortunately, not everyone who has children under age 17 will receive the additional money. If your adjusted gross income (AGI) is above $150,000 if filing Jointly, $112,500 for Head of Household, or $75,000 for Single, the amount of the credit starts to be reduced. The credit is reduced by $50 for each $1,000 over these AGI amounts.
Ex: Fred and Wilma have 2 kids, one who is 10, and another who is 5. Their AGI in 2021 will be $160,000. Their base credit is $6,600 because one child is under the age of 6. However, their credit will be reduced by $500 because their income exceeds the $150,000 threshold (($160,000 - $150,000) / $1,000 * $50). Their total credit will be $6,100 in 2021.
An important caveat to these thresholds is that they only apply to the expanded portion of the credit, not to the "normal" $2,000 base amount. It's possible to fully phase out of the expanded credit but still receive the full regular amount. The phase out ranges for this portion are much higher at $400,000 for Joint filers and $200,000 for those who file Single. Like before, for every $1,000 over these amounts the credit is reduced by $50.
Ex: Phillis files Single and has one child who is 16. Her AGI is $150,000 so she fully loses the additional $1,000 of the tax credit. However, because her income is lower than $200,000 she is still eligible for the full regular $2,000 credit with no additional phaseout.
Another slight change to the credit for 2021 is that it increases the age of a qualifying child by one year. Usually, the child must be under age 17 (16 or younger) but the American Rescue Plan increased it to children under age 18 (17 or younger). However, at this time the expanded age, along with the additional money, are scheduled to lapse after this year.
Is the Credit Refundable or Non-Refundable?
This is another huge change to the credit. Usually, the credit is only partially refundable (up to $1,400 of the full $2,000). Of course, if your tax liability was greater than $1,400 you could use more of the credit. In 2021, the American Rescue Plan allows the full credit, including the expanded amount, to be refundable. You read that right. The entire credit is refundable. This can be an enormous boon for lower-income individuals with children.
Ex: Peter and Mary Jane are married and have three kids age, 5, 7, and 9. Their AGI is $75,000 which is below the phaseout. Their total tax for the year is $5,000 and their base credit is $9,600. Since the full credit is refundable it eliminates their whole tax due, and they still receive a $4,600 refund! It's important to mention that this refund would be in addition to any other taxes already paid through work or other means.
Checks For Each Child?
A common occurrence from legislation to assist during the pandemic was direct payments to individuals, or commonly referred to as stimulus checks ("Stimmys" for short). The ARP kept the streak alive by issuing payments of up to $1,400 per individual if your income qualified. When it comes to tax credits, they aren't really beneficial until you file your return for the year. Before that, you're not able to use the money. While a larger refund (or less tax due) is nice, often it's more beneficial to have the money to use during the year.
An interesting experiment that they're trying with the Child Tax Credit is prepaying a portion of the credit during the year. These payments are scheduled to start monthly in July to be 50% of your estimated 2021 credit amount through December. The IRS will use your 2020 tax return as a reference to determine what your expected credit amount will be. A big difference between these monthly payments and the stimulus checks is that if you received more in payments than your calculated credit you may need to pay it back.
Clearly, this may be an issue for some taxpayers because the IRS is using your 2020 tax return in most cases to estimate the credit (unless your 2019 return is the most recent they have on file). For many 2020 was an unusual and stressful year from not only a personal but a financial standpoint. If your income was lower than normal last year and it recovers in 2021, there is a possibility you will need to pay some, or all, of it back. The IRS is hedging much of this by only pre-paying 50% of the expected amount and not the full credit, but there is a possibility that instead of receiving a credit that reduces your taxes, you instead need to repay a portion.
What's the Future of the Credit?
At the time of this writing, the enhancements to the Child Tax Credit only apply to 2021. However, these changes may be a teaser of tax legislation to come later on. The year has just begun, and with it, some significant changes to various credits and deductions in the tax code. The Biden administration is expected to propose additional tax legislation and expressed some of their policy goals in a recent address. Rest assured, as new tax legislation gets introduced and passed, we'll review them and highlight the important financial planning considerations, so you don't have to.
Nick Prigitano, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors.