Children = Tax Breaks, everyone knows that. But what you probably don’t know is how that tax break works. So let’s run through that before explaining what changed in 2021.
To simplify a tax return, and make this explanation palatable, let’s break up the individual income tax return into three sections. INCOME, DEDUCTIONS, and CREDITS.
INCOME – everything you brought in in a given tax year, even if it was immediately reinvested. Things like wages, interest, dividends, business income, capital gains for the sale of an asset are all considered taxable income.
DEDUCTIONS – you’re allowed to reduce your income by any deductible expenses. Those can be business expenses, mortgage interest, real estate taxes, charitable contributions, investment interest; they can all be used to reduce the amount of income you have in any given tax year. The amount left over after reducing your income by any deductions is your taxable income, which is the number used to calculate your tax owed.
CREDITS – instead of reducing the amount of taxable income that you have, which lowers the tax you owe, credits reduce the tax you owe, dollar for dollar. There are credits for purchasing an electric vehicle, education credits, adoption credits, and a few others that we see regularly, but the credit that we see most often is the child tax credit.
INCOME – DEDUCTIONS = TAXABLE INCOME x TAX RATE = TAX – CREDITS – TAXES PAID IN = TAX OWED WHEN FILING YOUR RETURN
In 2020, the child tax credit was worth $2,000 per child for taxpayers making $400,000 or less, filing jointly, and $200,000 or less filing single. So as an example, if you have three kids and earned $85,000 in taxable income, the tax you owe the IRS is $7,000, but because the IRS recognizes how special those sweet little angels are, they allow you to take $6,000 of child tax credits, so your actual IRS bill is only $1,000. It is a tremendous benefit that is overlooked because most taxpayers don’t care HOW the IRS got to the amount they owe; they care about which couch they’re going to find the money in.
So why am I telling you this? Well, keep all of what you just learned in mind, as it’s about to get more complicated.
The good news is that the child tax credit is still around; in fact, it’s gotten even more advantageous for some. If you’re single and earn $75,000 or less in 2021 and have a child under 6, you get the full credit of $3,600 per child! And if you’re married and combined with your spouse’s income, you make less than $150,000, with a kid under 6; you get the same increased amount. Anyone with a child over six but under 17 will get $3,000 per child in 2021. If you earn up to $200,000 single and $400,000 if filing jointly, and you still get $2,000 per child, just like in 2020, regardless of the child’s age. And if you make more than that, it slowly phases out.
Here is where things get tricky. They’re going to start giving you those credits upfront. Based on 2020 amounts, taxpayers who are due to receive a child tax credit, whether it’s $3,600 or $2,000, will start to receive payments from the IRS in their bank accounts. Their goal is to pay out ½ of the total credit over six months. So if the IRS projects that you’ll get a $3,600 child tax credit, they’ll pay you $300 per month for six months (July 2021 – December 2021), and then the remaining $1,800 you are owed will be available on your return as usual to reduce your tax owed.
This is wonderful to put some more money in your pockets, especially if you have a few kids and earn under the limits discussed above. But keep in mind what a tax credit is. It’s used to reduce the tax you owe. Before 2021 you had no choice but to take advantage of it when filing your tax return. But this year, you’re getting some of it early, so the benefit of it on your tax return will not be as great as it was in the past. So it’s crucial to keep an eye on what your taxable income is trending to be, so that you’re not shocked with a large tax bill when you file your return next year.
At the end of this month, June 2021, the IRS will issue guidance on how taxpayers can opt OUT of the advanced payment program. If you don’t need extra cash every month to float you, we’re encouraging taxpayers to opt OUT of the advanced payment program so that you get the full benefit when you file your taxes. If you receive the monthly payments, keep track of the payments because when tax time comes, that will be VERY important information to tell your tax preparer because the last thing you want to do is get too much of a child tax credit and eventually have to owe the overpayment back.