The recently passed American Rescue Act brings some sorely needed relief to American families, especially for lower and middle-income households. One of the most valuable pieces of the legislation for these families is the new child tax credit. According to the Institute on Taxation and Economic Policy, about 80 million children live in households that would benefit from this tax credit, providing families with children an average benefit of $2,750 and an average of $4,570 going to low-income families. As a result, many policy experts are calling this the most aggressive piece of anti-poverty legislation written in some time, if not ever, and with a lot of political backing, it could serve as a catalyst for more permanent support measures in the future. In this post, I will discuss what those changes are, how they work, and how you can make the most of it to improve your financial wellness.
How has the child tax credit changed?
The current tax credit has a limit of $2,000 per child, while the expanded 2021 tax credit increases this amount to $3,600 for children under age 6 and $3,000 for children ages 6 to 17 and makes it fully refundable. Additionally, the temporary changes will waive the $2,500 earning requirement so parents who aren’t employed can benefit. The changes will also lower MAGI caps to $75,000 for single filers, $112,500 for heads of household and $150,000 for married couples filing jointly. The qualification status will be based on either your 2019 or 2020 tax return information, depending on if you filed your 2020 taxes at the time payments are disbursed. Parents who aren’t eligible for the higher credit will still be able to claim the traditional child tax credit of up to $2,000 per child, granted they meet the eligibility requirements.
How does it work?
The first thing to be clear on is how a tax credit differs from a tax deduction. A tax credit reduces your tax bill dollar-for-dollar whereas a deduction reduces your taxable income used to determine your marginal tax bracket. Assume you were in the 10% marginal tax bracket and qualified for a $2,000 tax deduction. The deduction would mean that you get maximum tax savings equal to 10% of the 2,000, meaning a $200 tax benefit. In contrast, if you were to get a tax credit your maximum tax benefit could equal the full $2,000, which could mean an extra $1,800 in your pocket! As you can see, tax credits are more valuable!
In addition, parents will be able to get an advance on half of their 2021 credit, with monthly payments of $250 or $300 per child starting in July through December 2021. If this option is chosen, the remaining child credit will be given after filing 2021 taxes in 2022. You will also be able to opt out of the periodic payments if you prefer to take the full child credit on your 2021 return instead. This is a relief measure that has never been taken before and is expected to be very impactful as it will allow families to receive consistent monthly payments that they can set aside for any purpose they deem necessary.
Lastly, it’s important to note that while the IRS is using 2019 or 2020 tax returns to calculate your payment, once you file your 2021 return you may find that you may no longer qualify for the same amounts. As a result of this possibility, a safe harbor rule has been included to protect those whose MAGI is less than $40,000 filing single and $60,000 filing jointly from having to repay the credit when filing their 2021 tax returns. To make the process easier, the IRS is also expected to create an online portal to allow individuals to update their income, marital status and the number of qualifying children, which is expected to help expedite payments.
How can I use the child tax credit to improve my financial wellness?
You can use this tax credit calculator to get an idea of what type of tax credit you could qualify for. Based on your household income, filing status and number of qualifying children, you will get an estimate of your expected monthly payments in addition to the remaining credit that would be applied to your 2021 taxes. I ran an example for a family of 3 with one child under 5 and 2 children between 6 and 17 with a MAGI of ~$150,000. This family could be eligible for $800 a month in payments from July – December of 2021 and take an additional $4,800 tax credit on their 2021 tax return! Let’s look at how this family might make the most of these payments to address their financial priorities and improve their financial wellness:
Step 1: Consider establishing or replenishing emergency savings, especially if they have been spent down. The goal is to have at least ~$2,000 to help your family weather the one-offs that happen in life like covering a deductible on your car or homeowners insurance plan or dealing with an urgent medical need. An additional consideration is your income risk. If you have a large concern here, consider building your savings further to help cover a few months of expenses to give yourself some time to replace lost income. You can use this saving for goals calculator to help determine how far that credit can take you.
Step 2: Address debts. There are two basic strategies that most people like to employ. One is the debt snowball strategy where you focus on paying off the lowest balance debts first, and the other is the debt avalanche where you focus on paying the highest interest rate debts first. These 6 months of payments can help eliminate some monthly bills and help you save time and interest dollars on your debts! Check out this debt snowball calculator and this debt avalanche calculator to learn more about each and see what type of impact it can have in your situation.
Step 3: Consider using some or all of that income for childcare. Finances can be a major stressor, but there is no denying the massive amounts of mental stress this pandemic has caused everyone especially young families. If using some of those funds to help address your mental wellness would go a long way to help restore yourself and your family, then that is money well spent and allocated.
Imagine having some additional help for 6 months. What would that do for your mental health or your physical wellbeing? The benefits that you reap can last far beyond the 6 months and help serve as a catalyst to help you make your next best money and life moves! Here are some creative ideas to provide childcare during these times. It is also worth noting that your employer may offer a childcare benefit, an on- location service, and/or discounts so be sure to check those out as well.
Lastly, if you find that your finances have luckily not suffered or find that there is some bandwidth fora additional spending, then consider treating yourself or your family with a reasonable amount of that money while still setting some savings aside for your other financial priorities. It’s been a long, hard and tumultuous 12 months for all of us. Give yourself the permission to take a breath and celebrate the fact that there is hope on the horizon. This too shall pass, and these additional financial benefits can help you and your family usher in the better times with a little help from a generous child tax credit. If you need any additional guidance, please reach out to a trusted financial professional or a financial coach offered by your employer’s financial wellness benefit.