The American Rescue Plan Act (“Act”), passed in March 2021, provides significant benefits for taxpayers with children. Today we will discuss the increased tax benefits, which are applicable only to tax year 2021. These benefits will revert to their previous amounts and limits unless extended by future legislation.
Child Tax Credit
The Act introduced an enhanced version of the child tax credit applicable to tax year 2021. Taxpayers with adjusted gross income (AGI) under a certain threshold qualify for the enhanced credit. Those over the threshold would still qualify for the original (not enhanced) child tax credit. The chart below summarizes the original and enhanced credit details:
The Act directs the IRS to pay half of the original or enhanced child tax credit in advance for those who qualify. The monthly payments to qualified taxpayers should begin in July 2021 and will be based on taxpayers 2020 tax returns or 2019 if their 2020 tax return has not been filed. For those who qualify for the enhanced credit, the monthly payment is expected to be $250 per child ($300 for those 6 and under). For those above the income threshold but still under the previous child tax credit limit, the payment is expected to be $167 per child for the last six months of 2021. The advance payments will be reconciled with the actual credit the taxpayer is eligible for on their 2021 tax return, therefore taxpayers should keep record of the payments they receive.
The IRS is setting up a portal for taxpayers to update their dependent information if they expanded their family in 2021. Opting out of advance payments will also be an option on the portal.
The advance child tax credit payments will not be reduced for back taxes or child support.
Child and Dependent Care Credit
The Act also enhances the child and dependent care credit. This credit covers child and dependent care expenses to allow a taxpayer to work. Expenses such as after-school, summer day-camps, and day care for younger children generally qualify. The total qualifying expenses allowed for the credit prior to 2021 was $3,000 per child under 13-years old ($6,000 for two or more children). The new limit for 2021 is $8,000 per child ($16,000 for two or more children). The credit limitation also increased from 30% to 50% of qualified expenses; however, the limitation can be reduced from 50% to 0% based on taxpayers’ AGI. Those with under $125,000 of AGI will qualify for a credit of 50% of qualified expenses, while those with AGI over $438,500 will not qualify for the credit. Everyone in-between will qualify for a sliding-scale percentage of between 49% - 1% of qualified expenses.
Dependent Care Flexible Spending Accounts
One of the simplest changes of the Act relates to dependent care flexible spending accounts (FSA). The maximum amount taxpayers can contribute to an employer-sponsored dependent care FSA increased from $5,000 to $10,500. Taxpayers should consult their employer’s human resources or benefits professional to determine how to make changes to their current contribution election.
Important Note: Amounts contributed to a dependent care FSA, but not used, may be lost. Thus, taxpayers should take care in calculating their expected 2021 childcare expenses and related contributions to dependent care FSA. This includes being mindful of 2020 contributions rolled into 2021 due to pandemic related closures.
Coordination of Dependent Care Benefits and Dependent Care FSA Contributions
Due to the increase in qualified expenses and the credit limitation increase to 50%, the dependent care credit may be more beneficial than contributing to the dependent care FSA. If a taxpayer’s dependent care expenses will qualify for the 50% credit, taking the credit instead of contributing to the FSA will result in lower overall tax liability.
If a taxpayer’s expenses exceed the new limit for the dependent care credit, they can claim the credit up to the maximum amount allowed but also contribute the excess to the dependent care FSA.
A computation that considers a taxpayer’s expected income and eligible dependent care expenses in 2021 can help determine the optimum amounts to contribute to dependent care FSA.
For now, the increased benefits provided by the Act are only applicable for tax year 2021 and will revert to 2020 rules in 2022 and forward absent future legislation. The Tax Warriors® at Drucker & Scaccetti will monitor guidance on these benefits and to keep you up to date on the upcoming IRS child tax credit portal and other changes as more information becomes available.