The American Rescue Plan Act of 2021, signed into law on March 11, 2021, made significant changes to the US tax code, especially as it applies to individuals and families. Some aspects of the law provide funds to individuals and families through direct payment. Other changes impact child-related credits and expand the Earned Income Tax Credit so more individuals qualify. The cumulative impact of these changes is unprecedented. Families eligible for multiple 2021 initiatives will likely receive over $20,000 in transfer payments. This article will focus on changes to the Earned Income Tax Credit. But, before we begin, let’s review a few of the acts significant provisions:
- The Third Direct Stimulus Payment: The American Rescue Plan 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. They are income-limited advances of a refundable tax credit calculated on 2021’s tax return.
- 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 discussed these changes (and an impending mess) in an earlier article posted on our website.
- 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 or 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 discuss these changes below.
The Earned Income Tax Credit History & 2021 Changes
The individual tax return, Form 1040, holds a unique position in US domestic policy. Form 1040 is the only document most Americans must submit to the federal government annually (since 1916). Initially, the form had a single purpose – to collect taxes on income. At the time, only those with inflation-adjusted incomes of roughly $70,000 and up paid any tax.
Over time, however, congress realized the annual filing requirement made the tax return an efficient way to enact politically-influenced policies. These policies often benefit lobbyists and special interests by reducing their costs (and increasing profit) and by influencing consumer behavior. Many purchase-related credits and deductions trace to these efforts. Over time, policymakers came to realize that the annual filing requirement made Form 1040 an efficient vehicle to direct taxpayer dollars to other groups, especially those with children. These measures take the form of credits augmenting social welfare programs. A few are listed in the introduction above. The Earned Income Tax Credit is a near-perfect example of your tax return’s increasing role in welfare administration.
The Earned Income Tax Credit first arrived in 1975 as a temporary measure to encourage work and reduce growing dependence on welfare. The credit was equal to 10% of a qualifying taxpayer’s first $4,000. The maximum credit was $400. That year, 6.8 million tax-filers received an average credit of $201. The $400 maximum equals $1,977 on up to $19,770 of income when adjusted for inflation. The average EITC recipient received the equivalent of $989 in 2021 dollars.
Today: Let’s fast-forward to 2018, the most recent year with reliable data. The 1975 tax credit, which was supposed to be temporary (and reduce welfare dependence), has ballooned to BECOME a mammoth welfare program. In 2018, 26.5 million return-filers collectively received $65 billion in Earned Income Tax Credits. The average payment per recipient was $2,449, nearly 250% of the average 1975 inflation-adjusted payment.
Error & Fraud Monster: In 2021, tax-filers can earn up to $57,414 and receive the EITC credit. The maximum credit is $6,728. That’s a ton of money and a significant fraud incentive. The EITC is so complex and lucrative that the IRS estimates that 20% to 26% of EITC payouts are erroneous or fraudulent. That’s over 6 million payments costing US taxpayers between $13.6 Billion and 16.9 billion annually.
The EITC, combined with other income-based assistance program credits, has made much of a tax professional’s work that of a highly scrutinized social worker. If you’ve received the EITC and questioned the plethora of statements and signatures we require. Rampant fraud is your answer.
Big EITC Changes for 2021
The American Rescue Plan (ARP) substantially changed the EITC. Some changes impact both 2021 and future years. Modifications providing the most significant financial impact, however, affect 2021 only. Because these changes are short-lived, they are easy to overlook. Here’s a quick rundown of ARP changes to the Earned Income Tax Credit.
2021 and Future Years: Here are some of the EITC changes for 2021 that carry forward into the future.
- Non-Qualifying Children: Taxpayers with children who do not qualify for the EITC are allowed to claim the EITC as a taxpayer who has no qualifying children. For some unspecified reason, before 2021, this was not allowed.
- Those Married Filing Separately May Qualify: Before 2021, anyone who was married but filing a separate return from their spouse could not claim the EITC. Beginning in 2021, married taxpayers who filed separate returns can qualify under one of two conditions:
- They do not reside with their spouse for the last six months of the year and reside with a qualifying child for at least ½ of the year, OR
- They have a formal separation or maintenance agreement and do not live with their spouse at the end of the year.
- Investment Income Increase: I believe this is a BIGGIE for 2021 (especially for retired filers). Beginning in 2021, taxpayers can earn up to $10,000 of investment income (interest, dividends & capital gains) and still qualify for the EITC. Additionally, the $10,000 gets adjusted for inflation and will increase with the cost of living.
EITC 2021-Only Changes: Several EITC changes made by the American Rescue Plan only impact 2021. Many filers, particularly the retired, young, and those lacking qualified children, will benefit from a temporary expansion in EITC eligibility. But, because this expansion is for one year only, it will be easy to overlook. Below is a list of 2021-only changes:
- Change in Qualifying Ages: Before 2021, an individual who lacked a qualifying child had to be over age 24 and under 65 to receive the Earned Income Tax Credit. For 2021, however, the lower age restrictions are modified - the minimum age is 19, and there is NO maximum age. As a result, nearly all filers will qualify provided they: 1) Are not a dependent or qualifying child of another, 2) Have earned income (basically W2 or self-employment income), and 3) Have total income below the maximum allowed.
For 2021, this maximum income (based on Adjusted Gross Income) is $27,380 for those married filing jointly and $21,430 for other filers.
The ARP made three other 2021-only age-related EITC changes. Individuals considered Specified Students who lack a qualifying child will qualify if they are at least 24 years old (25 other years). Also, for 2021, two new classes of filers are eligible for the EITC - Qualified Former Foster Youth and Qualified Homeless Youth at least 18 years old.
- Increase in Credit Maximum: Another significant change impacting those lacking a qualifying child is a large increase in the maximum credit they can receive. For 2020, the credit maxed at $538. But in 2021 (only), it’s increased nearly three-fold to $1,502.
- Opportunity to Calculate EITC Using 2019 Income: This pandemic-related change extends a 2020 modification. In 2021, those having higher earned income in 2019 than 2021 can use that income to calculate their 2021 Earned Income Credit if it generates a higher credit.
Alert - Retired Part-Timers: The 2021 changes create an opportunity for many retirees to benefit from the Earned Income Tax Credit. Why? Social Security is not taxable until modified income (it’s complicated – basically other income plus ½ of social security) reaches $25,000 for single filers and $32,000 for those who are married). As a result, many recipients’ Adjusted Gross Incomes will fall under the threshold required to receive the EITC. The removal of the upper-age limitation and the increase in allowable investment income will result in many retirees with W2. So, let your retired friends know!
Take Away: The Earned Income Tax Credit exemplifies the changing nature and increasing complexity of the individual tax return. The many changes made to the tax code for 2021, including the Earned Income Tax Credit, will undoubtedly benefit many return filers. However, these benefits will not arrive without a cost – not just in terms of public funds – but by generating the same confusion, frustration, and delays that plagued 2020’s filing season.