Advance Payments of the Child Tax Credit

By: Sam Brunson

Yesterday my neighbor texted me to mention that three pieces of my mail had been left in his mailbox; he dropped them off in front of my door. Two were just standard junk mail but one is potentially important: a letter from the Department of the Treasury.

Perhaps you also got this letter: it has some important information about the way the the child tax credit now works. In short, the American Rescue Plan, a law signed in March, makes a number of significant changes to the child tax credit.

Two of those changes are particularly notable. First, it increases the amount of the credit to $3,000 for most children and $3,600 for children five and younger.

Second, it makes allows the IRS to make advance payments of the child tax credit. Essentially, unless parents choose otherwise, starting in July the will receive monthly payments of $250 or $300 per child (depending on the child’s age).

Third, the credit is fully refundable. Even if a parent doesn’t have enough income to owe taxes, they will receive the full amount of the child tax credit.

Finally, the age limit for the child tax credit has been increased from 16 to 17. (Note that currently these changes are all temporary–they only apply to 2021, though the may be extended as some point.)

These changes to the child tax credit are really exciting. The Tax Policy Center estimates that the combination of advance payments plus the increased credit will cut child poverty by half! And getting advance payments will help families pay their ordinary bills (rent, food, clothing, etc.) when those expenses arise rather than waiting until they file their tax returns. (Parents who didn’t file a tax return last year or who had an additional child won’t receive the advance payments automatically, but they can sign up here.)

One caution about these advance payments, though: they will almost certainly reduce parents tax refunds.

This reduction is good economically! It’s more valuable to have the money now than later. (There is a technical explanation for this that even has a name–time value of money–and if you’re interested in why advance payments are more valuable than the same payments later, you can read more about it here.)

But if you’re not prepared, you may be disappointed when you do your taxes early next year.

Understanding what I mean will be easier with an illustration. Let’s imagine we have a married couple with a two-year-old daughter. The married couple files a joint return and they earn Illinois’s median household income of $65,886. All of their income is wage income and, like nearly 90% of Americans, they don’t itemize.

Ignoring the child tax credit, the couple will owe federal income taxes in 2021 of $4,496. The child tax credit will reduce their income tax liability to $896.

But here’s the thing: when they file their tax return, they’re not going to attach a check for almost $900 because their employers have been withholding taxes from their paycheck and sending that money to the IRS during the whole year. Let’s say their employers withhold $100 from their paychecks every month. That means that during 2021, the couple has prepaid $1,200 in taxes.

But it turned out that they only owed $896 in taxes! Because of withholding, they overpaid. So when they file their 2021 tax return, they’ll end up getting a refund of $304 from the government.

The advance payments of the child tax credit changes this calculus though. Because now our married couple will get a $300 check from the government for the last six months of the year, for a total of $1,800.

That $1,800 doesn’t come out of nowhere, though. Remember, the reason the couple owed $896 rather than $4,496 was because the child tax credit reduced their original tax liability by $3,600. It still does that, but the reduction is being paid in advance.

With those advance payments, then, their $4,496 tax bill has already been reduced by $1,800 when they file their tax return. It is only going to be reduced by another $1,800. As a result, the couple is going to owe $2,696 in taxes when they file their return. They’ve still prepaid $1,200 through withholding but now, rather than receiving a $304 refund from the government, they’re going to owe $1,496.

It is important to keep in mind that the couple has paid precisely the same amount in taxes either way. But with the advance payments of the child tax credit they were able to spend money currently rather than wait for it to come. Still, if they didn’t understand that receiving advance payments would reduce their tax refund, they’re going to be in for a surprise when they file their tax returns.

So what can they do about this? There are a couple options. They can do nothing and save a portion of the monthly payments (in an interest-bearing savings account ideally!) so that they have enough cash to pay their increased tax bill later and spend the rest on current expenses (or save it or invest it or whatever they need to do).

They can file an amended W-4 with their employers so that their employers withhold more every month and they don’t face such a large bill at the end of the year.

Or if they don’t want anything to change and just want a big tax refund when they file their returns, they can even opt out on a soon-to-be-released IRS child tax credit portal.

It’s important to keep in mind that my hypothetical family was just that: hypothetical. I ignored payroll taxes and made up numbers for withholding and income and even number of children. Your situation is almost definitely going to differ in the details from what I laid out.

But the broader strokes will apply. That is, the advance payments of the child tax credit are good both because they will reduce child poverty and because it is more valuable to receive money now than later. Just remember that because the advance payments reduce the amount of child tax credit that is left when parents file their tax returns, their tax refund may be smaller than they expect.

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