Your client, we will call him Mark Smith, calls to ask why he and his wife received a direct deposit into their checking account for $550. They had already received their stimulus check and he wasn’t aware that they were eligible for another.
The deposit was the first monthly payment for the advance child tax credit for their two children. In 2020, the Smiths were hit pretty hard by the pandemic but in 2021, Mark is on track to make more than he did in 2019. This could present some opportunities and potential difficulties for the couple on their 2021 tax return.
On July 15, 2021, the Internal Revenue Service began sending the monthly payments for up to $250 (for dependents age six to 17) or $300 (for dependents age zero to five) to couples with a gross income of less than $150,000 and single parents with a gross income of less than $112,500, based on a taxpayer’s most recently filed tax return. The credits are expected to continue through December 2021.
Since the credits are based on having a qualifying child, it is also possible that many grandparents raising their grandchildren will be able to claim these benefits. To do so, they will need to be able to claim the children as dependents on their return.
Two Significant Changes
Taxpayers can either receive the payments in advance or can opt out and receive any amount due when the 2021 return is filed. Unlike the recent pandemic stimulus payments, the child tax credit will reduce the amount of any refund owed to the taxpayer and may increase any amount due to the IRS. The increased credit is currently only available for 2021, unless extended by Congress.
The child tax credit was created through the Taxpayer Relief Act of 1997 as a way to provide relief to middle and upper-middle income families. The American Rescue Plan Act of 2021 changed the child tax credit in two significant ways:
- It increased the credit for 2021 from a potential $2,000 per dependent child to $3,000 (for dependent children ages six to 17 during the calendar year) or $3,600 per dependent child (for children who are under age six during the calendar year).
- It allowed for a portion of the total credit to be paid as an advancement, which is why some taxpayers started receiving checks in July. As of the writing of this article, the advance payments for the child tax credit will end in December of 2021.
The phaseouts for modified adjusted gross income to qualify for the child tax credit is the same for 2021 as it was for 2020.
Let’s get back to our example. Mark and his wife, Carolyn, have a 3-year-old son and a 7-year-old daughter. The $550 direct deposit the couple received was the first advance child tax credit payment.
As their advisor, you pause to take a breath thinking about how this is going to impact Mark and Carolyn. We know the couple earned more in 2021 compared with 2020. Although they were mailed the advance child credit payments, they actually may be ineligible to receive them because their income may exceed the limit. Not only will they need to repay those credits, they may also face a penalty.
Additionally, the advance child tax credit payments could lead to an Underpayment of Estimated Tax by Individuals Penalty both at the federal and state level if the total withheld, along with quarterly estimated payments and tax credits not yet received, do not meet the guidelines.
Your second thought is about the recordkeeping involved in these brand new payments. The IRS is already behind on processing 2020 tax returns and a majority of the calls made to them are unanswered. So you are concerned that if discrepancies exist between what a taxpayer believes they were refunded and what the IRS says they were refunded, correcting them may be a challenge.
For example, how would Mark and Carolyn go about requesting a corrected document if what they received doesn’t match the records maintained by the IRS? Also, how will these differences be addressed at the state level? The IRS has promised to send a letter in January 2022, showing the amount distributed to the taxpayer for these credits.
To determine if a client is eligible for these payments, the IRS provides this tool.
In Mark and Carolyn’s situation, the monthly advance child tax credit payments of $550 that they are slotted to continue to receive will likely result in an overpayment and possibly penalties. Therefore, it’s important to look at the planning opportunities available to them and other taxpayers with dependent children or grandchildren.
Planning Options for Clients Receiving Payments in 2021
Taxpayers who are eligible for these payments may choose to use them to increase their pretax 401(k)/403(b)/other workplace plan or deductible IRA contributions, or make deposits to a health savings account (HSA). Business owners may also be able to open a workplace retirement plan (such as a SIMPLE IRA, SEP IRA or 401(k)) or benefit plans such as a health reimbursement arrangement (HRA). By using these payments to make contributions, taxpayers can improve their 2021 tax situation.
Taxpayers looking to use the advance payments to impact their long-term net worth may consider making contributions to Roth 401(k), Roth 403(b), or other workplace plans. They may could also consider Roth IRA or 529 contributions. While this will not reduce the amount of tax paid in 2021, these options may fit as part of their overall strategy.
In Mark and Carolyn’s case, they could increase their pretax retirement contributions to partially offset the overpayment from the advance child tax credit payments. Due to the complexity of these calculations, taxpayers should consult with their tax advisors.
Planning Options for Clients Not Receiving Payments in 2021
As another alternative, taxpayers who opt out of receiving the advance child tax credit payments in 2021 may consider using the anticipated tax credits to fund a Roth conversion strategy by using the credit to pay the additional tax due.
This will require careful planning as the conversion must be completed prior to December 31, 2021, and the credits will only be one part of the overall tax reporting. Taxpayers should coordinate this strategy with their financial advisor and tax professional well in advance of the year-end deadline. Remember, there is no income limit or cap on Roth conversions, as long as you have the money to pay the tax bill.
This is going to be a tricky year for many taxpayers. Thoughtful and timely planning will be critical to navigate these challenges and opportunities.
John M. Gehri, CFP, ChFC, and Monica Dwyer, CFP, CDFA, are advisors with Harvest Financial Advisors in the Cincinnati/West Chester, Ohio area. John may be reached at firstname.lastname@example.org. Monica may be reached at email@example.com.