Child Tax Credit 2021 and beyond
The 2021 Child Tax Credit
In recent years, the Child Tax Credit (CTC) has undergone several changes, and is currently is a negotiation piece within the Democratic party as more conservative members are seeking to alter proposals within the Build Back Better Act.
For 2021, there are five key changes:
- It increases from $2,000 to $3,000 per child under 17. Children under 6 (on 12/31/2021) are eligible for an additional $600 for $3,600 total.
- No longer requires earned income.
- Credit becomes fully refundable vs partially.
- Advance payment of the credit is being made via monthly deposits to taxpayers bank, vs being claimed when filing (which is going to cause headaches later).
- There is a two-step phase out based on modified adjusted gross income (MAGI).
The conservative element is pushing back on the earned income (or pursuing education) requirement and seeking to lower the phase out range from $150,000 to $60,000.
Tax credits are either 'refundable' or 'nonrefundable'. The refundable credit can take liability below zero, creating a refund, whereas a nonrefundable credit cannot create a refund. Refundable credits are much more attractive to the taxpayer, and ensure that everyone within the income range gets the entire credit. When there is a nonrefundable element we essentially create both a floor and a ceiling to the credit. This occured with the TCJA increase (from $1,000 to $2,000) which helped middle income taxpayers more than lower income.
The Two-Step Phase Out Process
When in a phase out stage, the credit is lowered by $50 for every $1,000 of income in excess of the income limit. It is two-step because it starts in Phase 1 and then stops until the taxpayer reaches Phase 2. The Phase 1 phase will only impacts the 'enhanced' part of the credit (the amount in excess of $2,000). For single filers, the phase out starts at $75,000. Head of Household $112,500 and MFJ $150,000. The chart below shows the two phases for MFJ.
The Timebomb from Advanced Payments
The 2021 CTC includes advanced payments on a monthly basis, whereas prior years the credit less visible, and occured when filing taxes. Again, when it was nonrefundable, some taxpayers never really saw this (at least not in full). However, what would happen is that tax was lowered, which may or may not have created a refund. Today, the CTC is being sent out monthly to taxpayers. This means that when filing the tax return will not have a credit. I have seen examples in 2020 where a self employed parent might generate a tax liability of $6,000 prior to using the CTC, but owes $0 due to being the parent of three children. That person may pay no estimated tax during 2021, but also receive $9,000 in credits. When filing taxes they will have paid $0 and still owe $6,000 which might also have penalties and interest attached!
If you are in this situation and have access to payroll, using withholding is better way to catch up tax payments later in the year, because withholding tax is always considered paid on January 1st, whereas estimated tax is considered paid when remitted (IE it would be late).
Payroll remitted is always timely paid, use it to catch up by adding additional withholding.
Tax Planning with the Child Tax Credit
Managing your MAGI. Note that most filers will use Line 11 of the 1040 for MAGI (the AGI). The "M" in MAGI is the modification made to Line 11, which differs based on the credit in question. For the CTC, the modifier is foreign (including PR and American Samoa) earned income. To plan around the CTC you need to recognize how the lines work on the 1040.
CTC Planning is limited in scope to cases where you are near one of the two phase out steps. A taxpayer (MFJ) with $300,000 of income isn't going to be able to pull themselves back into a credit that exceeds $2,000, but the MFJ taxpayer who is on target for a MAGI of $184,000 could find benefit. There are two strategies, lower the additive items, and raise the deductive items.
If we look at the 1040, the lines we can impact are as follows:
- Line 1 Wages = lower via paycheck pretax items (401(k), HSA, medical etc).
- Line 2b Interest = use mortgage as tax deferral tool or gift down to children.
- LIne 3b Dividends = tax location (avoid dividend stocks in taxable), gifting down if appreciated.
- Line 4b IRA distributions = avoid pretax element of conversion (use only when intentionally increasing income).
- Line 5a Pensions and Annuities = avoid annuities.
- Line 6b Social Security = delay for enhanced future benefits and use interim to control MAGI.
- Line 7 Capital Gains = Loss harvest up to $3,000 can be a negative line item for MAGI.
So, while many wage earners bemoan the fact that aren't many options available to them, there can be lots of planning opportunities providing that their broader financial picture is well constructed.
For example, it is very common to have a person with a mortgage (paying 3% interest) which is never fully tax deductible, and who is also earning taxable interest which is always fully tax includable. Also, it's likely they are earning at a rate of 0.01%. If they instead sweep the cash into the mortgage it becomes an insulated wrapper (similar to the annual benefits from a 401(k)) for the purposes of MAGI, and will eliminate Line 2b impact.
Also, appropriate gifting of assets to children (within the gift tax and kiddie tax guardrails) can be an effective strategy to lower these income levels.
Schedule 1 Clues
The 1040, being a postcard, sends us to Schedule 1 for further planning opportunities.
Strategies for Schedule 1
- If you didn't max out your HSA via payroll (which is the superior method due to FICA exemption) you can top it up manually until 04/15.
- Traditional IRA deduction can be made until 04/15. Often, the primary taxpayer may be over the income threshold for deduction of the Traditional IRA, but in the case of a non-working spouse, there is a Spousal IRA option that is frequently overlooked.
- If you had a business that loses money, you can deduct it.
- If you had a business that made money, you can deduct health insurance and retirement plans here.
- Rental losses are deductible up to $25,000 when AGI is under $100,000 (a taxpayer here would already get the full CTC, but you can see how deductions on the Schedule 1 can combine and cascade).
- Taking the tuition and fees deduction instead of the American Opportunity Tax Credit would lower MAGI (but at the cost of the more attractive credit, so it is a Hail Mary and needs to be modelled carefully).
- W2-G recipients can use session based netting to calculate their net win/loss via Schedule 1 rather than rely on Schedule A, thus keeping MAGI low. Retirees use this to reduce the tax social security benefits (MAGI is used in many places beyond the CTC).
Many of these are tweaks and adjustments, but when combined it is possible fine tune MAGI and increase credits. However, it is important to run multiple scenarios because the CTC is only one of many credits available, and sometimes it is beneficial to move MAGI upwards, as well as downwards to capture the best benefit overall.
Swapping Government Cash for Appreciated Assets
A fun example of planning could be found with an employee of a Utility company that participates in an Employee Stock Purchase Plan (ESPP). Often, such employees will hold the stock long term and it has appreciated over time. This creates a quandry:
- Should I sell, and create a capital gain?
- Should I hold, and receive a dividend (Utilities tend to pay high dividends)
Also, while the best plan is always sell ESPP on the day of grant, some companies will enforce a holding period which could be up to 12 months, meaning that this question will arise annually.
If the stock was valued at $100,000 with $3,000 of capital gains, and 3% dividend, the choice to hold vs sell is equal (for purposes of MAGI in the current year). If the individual was at $182,000 MAGI excluding this stock, then each $1,000 of gain or dividend would cost $50 of lost CTC. Doesn't sound like much, but remember that this is 'per CTC' IE, per child.
Solution: Gift and Kiddie Tax Rules
The taxpayer could gift $30,000 (if married and splitting the gift) to each child. If we have 4 children, split gifting $25,000 to each completely moves the $100,000 out of the parents 1040. The $3,000 of MAGI saved results in $600 ($150*4) increase to the CTC.
Kiddie Tax occurs with unearned income to the child above $2,200 for 2021
When Kiddie Tax occurs, the child must either file (and pay) tax on their own 1040 at their parents tax rate, or the parent can report it on their 1040 to avoid the filing requirement.
Interestingly for CTC planning, we could argue that 'we don't care about Kiddie Tax' because even if we are subject to paying it, we moved it away from MAGI on the parents return, and instead report it on the child 1040. Doing this doesn't avoid the tax due on any excess above $2,200, but it does allow us to capture the CTC.
Note that with Kiddie Tax, all children sum to $2,200, so in this fictitious example, if the children hold the stock they receive $750 per child, and trigger Kiddie Tax. However, dividends are often paid quarterly, so it is possible that if you gifted in Q3, you could have the children realize $2,200 in capital gains by selling in the current year, wait until January 1st to sell the remaining stock, and even if there was an ex-date in the interim, the sum of $800 capital gains and dividends receivable would be lower than the 2022 kiddie tax limit.
The final piece of the Kiddie Tax strategy would be to push the cash that was cleaned of unrealized gain back out of the child account and into something that is further tax advantaged, such as a 529 or additional mortgage payments. Doing this can require coordination with other factors in the tax code, such as dependent support tests.
The end result: increased credits are captured, appreciated assets that caused a roadblock are liquidated at a no cost (or low cost, keep an eye on state taxation here too!) and with an added benefit of diversification from employer risk.
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