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The American Rescue Plan & The 2021 Child Tax Credit Mess

As 2021 comes to a close, most of us are busy preparing for the holiday season – buying gifts, decorating, attending events, planning schedules, and untangling exterior lights.

Far be it for me to dampen the season’s excitement and frivolity (sorry- it’s my job). But, I would be duty-derelict if I didn’t highlight a few significant changes to 2021’s tax rules, especially those impacting nearly all citizens and families with children.

In this article I’ll highlight some changes sure to impact most 2021 returns. Then, I’ll dig into the details of the 2021 Child Tax Credit. These changes are significant, one year only, and affect most families with children under 18 years old.

Individual 2021 Tax Changes

The American Rescue Plan Act of 2021, signed into law on March 11, 2021, doubled down on the COVID-related theme of pumping stimulus into the economy. Many provisions of the law provide funds to individuals and families through direct payment, changes to several child-related credits, and expansion of the Earned Income Tax Credit. The cumulative impact of these changes is unprecedented, resulting in single-year transfer payments of well over $20,000 to many qualifying taxpayers. Here’s a brief list of the major provisions:

  • The Third Direct Stimulus Payment: The law authorized the third round of Covid-19 stimulus, up to $1,400 for each eligible individual. Taxpayer and their dependents, even dependent adults, qualify for the $1,400. Like 2020’s stimulus, the payments do not get taxed as income. Instead, they are income-limited advances of a refundable tax credit calculated on 2021’s tax return.

    The two advance credits received in 2020 (and early 2021) caused a great deal of confusion for 2020 filers who couldn’t recall the exact amounts. We expect the same for 2021. Reporting an incorrect advance will cause an incorrect credit filed on the tax return. These errors result in refund delays, IRS notices, and even tax bills sent to the filer. To avoid a repeat of 2020, take care to document the amount of stimulus received this spring.

    There’s a silver lining of good news for those receiving more stimulus advance than they were entitled. As the rules stand now, you will not have to repay the overpayment.
  • Child Tax Credit: The amount of the credit increased by $1,000 for each qualifying child under age 18. For 2021, it’s $3,000. Also, in 2021, the credit increased $1,600 for children under six years old to $3,600 per child. We discuss these changes in detail below.
  • Dependent Care Credit: The child care credit increased from a maximum of 35% to 50% of daycare eligible expenses. The maximum credit also took a mammoth leap. In 2020 the credit maxed at $3,000 for the 1st child and $6,000 for two of more children. For 2021, the maximum credit for one child is $8,000 and $16,000 for two or more children. That’s right, for 2021, the full dependent care credit increased by $10,000! We will expound on these changes in a future update.
  • Earned Income Tax Credit: The American Rescue Plan expanded the credit to many filers who did not previously qualify, primarily those who lack qualifying children. It also nearly tripled the maximum credit for these filers. Additionally, filers can now earn up to $10,000 in investment income and still qualify for the credit. We’ll also spotlight these changes in an upcoming article.

2021 Child Tax Credit & the Soon-Arriving Mess

Want to witness a giant mess? You won’t have to wait long. In July of 2021, millions of parents started receiving advances on their 2021 tax refunds. These advances are based on their 2019- or 2020-income tax return and take the form of early payment of the Child Tax Credit. How might this create a mess? To illustrate, allow me to share an analogy. The 2020 advance COVID stimulus payments generated a great deal of confusion. We could compare this mess to what my wife says the kitchen looks like after I cook (it’s not that bad, really). In comparison, the chaos anticipated by 2021’s Advance Child Tax Credit is a triplet’s first-year birthday bash. Cake and icing on faces, clothes, furniture, and ceiling – BUT, not as cute or easily cleaned. Want to learn more about 2021’s Child Tax Credit and its impending mess? Read on.

2021 Child Tax Credit Increase: The American Rescue Plan Act of 2021 made significant changes to the Child Tax Credit. As it stands now, these changes are only for 2021. Without legislative intervention, in 2022, the child tax credit will revert to 2020’s rules.

In 2020, the tax credit was generally $2,000 for each child age 16 and younger. Up to $1,400 of this $2,000 was refundable, meaning parents could receive the money even if they didn’t owe any tax.

For 2021, the Child Tax Credit increased to $3,000 per child under age 18 - the maximum eligible age increases from 16 to 17. Additionally, for children ages five and younger, the credit per child increases to $3,600. There are two other significant changes this year. In 2021, the entire credit is refundable! Additionally, unlike other years, those who qualify do not need earned income to receive a credit advance.

2021 Income Limitations: For 2021, the income levels of those who qualify are substantially reduced. In 2020 (and without further legislation, 2022 and future years), married taxpayers filing a joint return could have a modified adjusted gross income (MAGI – basically, your total income with a few changes) of $400,000 and $200,000 for other filers before the credit phaseout.

For 2021, the MAGI needed to receive the full expanded child tax credit is $150,000 for those married filing jointly, $117,500 for heads of household, and $75,000 for single filers. Having income above these levels does not mean you automatically lose the credit, but the $1,000 ($1,600 per child under six) bump up gets reduced, but not below $2,000. Then, once income reaches the $400,000 and $200,000 limits mentioned above, the remaining $2,000 gets chipped away until it’s gone.

The Credit Advance Mess: I introduced the 2021 Child Tax Credit by asking if you wanted to witness a mess. If you answered “yes,” and desire a firsthand experience, take a seat in a Tax Pro’s lobby (or outside of our virtual office window) and wait. Eventually, the chaos will unfold. Why? As part of the American Rescue Plan, Congress decided the IRS would take a peek at filers’ 2019 or 2020 tax returns. Then, based on the most recent return filed, send half of 2021’s Child Tax Credit as an advance. It wasn’t a joke. The IRS did it!

In July 2021, upwards of 36 MILLION parents started receiving checks and direct deposits of $250 and $300 per child per month. Many had no idea as to what the payments were. Those who didn’t regularly reconcile their bank accounts had no idea they received the directly deposited funds. It’s highly probable that a fair percentage of the 36 million (that’s 36,000,000) still don’t know they received the payments.

And here-in lurks the mess - like the 2020 (and 2021’s) stimulus checks, filers must accurately report the advance on 2021’s tax return. By doing so, those who didn’t receive the full advance will receive it on their return. On the other hand, many who received incorrect advances will have to repay all or a portion (discussed below).

The anticipated errors generated by this reconciliation have tax pros expecting an inordinate amount of confusion, notices, and angry clients. Recent conversations with IRS employees reveal anticipatory anxiety interspersed with curses targeting congress’s lacking forethought and common sense.

Here’s a brief list of expected mess-causing glitches:

  • Check Mailed to Incorrect Addresses: If a recipient moved since their last tax filing and didn’t receive a refund via direct deposit, the IRS will mail advances to the previous address. Many will not get forwarded, but the IRS will show the payments as made. How long does it take for the IRS to reconcile and remove uncashed checks from the recipient’s account? Consider this - checks are generally negotiable for 180 days. The last advance payment gets mailed in Mid-December. Boom! That’s a mess maker.
  • Checks Fraudulently Cashed: Undoubtedly, a portion of the check mailed to incorrect addresses will get cashed by the address’s occupants.
  • Children Not Claimed as Dependents in 2021: The IRS uses previously filed returns to calculate each advance. A dependent claimed in 2019 or 2020 is not necessarily a dependent in 2021. Consider the number of divorced parents who have shared custody and alternate dependency exemptions as a quick example.
  • Income Changes: Advances get sent based on income previously reported. How often does income change from one year to another? For many filers, a $10,000 earnings swing can result in an incorrect advance
  • Not Remembering the Correct Amount Received: Here’s a biggie. Let’s use 2020 as an example. Two stimulus payments got reconciled on the tax return. Many filers could not recall the amounts received during the year. Forgetting an entire payment was not uncommon – especially those received via direct deposit. The result: Credits claimed in error – adjustments, letters, confusion, and anger. In 2021, filers received one additional stimulus payment. They also received five or six advance payments for dependents claimed a previous year. Recollections a mere few dollars off will generate a cascade of delays, notices, and computer-generated changes.

You’re Supposed to Receive a Letter – Keep It: In January, the IRS is supposed to send a letter to recipients of the advance credit. The letter is called Letter 6419. It will list the advance payments received and the number of qualifying children used to calculate them. If you receive this letter, be sure to keep it and share it with your tax preparer.

Will You Have to Repay Advances Received in Error? Maybe. As mentioned, previously filed returns generated the payments. Those meeting the credit criteria in a previous year but not in 2021’s will have to repay the excess unless they qualify for a “safe harbor.” Those eligible for the safe harbor must meet two criteria. First, a change in the number of qualifying dependents claimed must cause the overpayment. And, second, those receiving the advance must have a certain level of income.

The maximum advance those meeting the harbor will not have to repay is $2,000 per child. To qualify, 2021’s adjusted gross income (AGI) must be below $60,000 for those Married Filing Jointly, $50,000 for those filing as Head of Household, and $40,000 for Single filers and those Married Filing Separately. As AGI increases, this non-repayment protection gets reduced. It gets eliminated (meaning repayment) once AGI reaches $120,000 for those Married Filing Jointly, $100,000 for Heads of Households, and $80,000 for single filers.

Conclusion: Yes – Advance Child Tax Credit will generate a mess this tax season.