After weeks of debate, President Biden signed the American Rescue Plan Act of 2021 into law on March 11, 2021. This act contains many provisions that directly impact young families, but this blog highlights the four provisions that I thought were most applicable:
- The stimulus checks/stimulus tax credit
- Increased child tax credit
- Increased child and dependent care tax credit
- The temporary removal of the student loan “tax bomb”
Ready? Let’s go!
#1) Stimulus checks/stimulus tax credit
The most popular aspect of the American Rescue Plan Act of 2021 is the stimulus checks. This is now the third round of stimulus checks. The first round was $1,200 per adult and $500 per child. The second round was $600 per adult and $600 per child. The third round will now be $1,400 per adult and $1,400 per dependent which is significantly more than the first two rounds.
However, as with the first two rounds, not everyone will receive a stimulus check. The checks “phaseout” if your adjusted gross income (aka AGI – line 11 from your most recently filed tax return) exceeds:
- $75,000 – $80,000 if you file taxes single or married filing separately (MFS)
- $112,500 – $120,000 if you file taxes head of household
- $150,000 – $160,000 if you file taxes married filing joint (MFJ)
For example, a married couple with two children that file jointly with an adjusted gross income of $140,000 would receive a $1,400 * 4 = $5,600 tax-free stimulus check.
Now, these stimulus checks are scheduled to go out quickly which means if you haven’t already filed your 2020 tax return, then your 2019 AGI will be used. So, if your 2019 adjusted gross income is below the AGI thresholds, then you will receive the full stimulus checks no questions asked.
But what happens if you would qualify for a stimulus check based upon your 2020 AGI and not your 2019 AGI? Unlike the prior stimulus bills, there will be a second date to determine your stimulus check eligibility if you did not receive one earlier based upon your 2019 AGI. This date is the earlier of 90 days after filing your 2020 taxes or September 1st, 2021. This means if your 2020 AGI is below the above thresholds, but your 2019 AGI is not, then you will be scheduled to receive a full stimulus later in the year.
Confused yet? Well, there is actually a third date to determine your stimulus check eligibility. Let’s say your 2019 and 2020 AGI was above the thresholds, but your 2021 AGI ends up below the thresholds. This means that instead of receiving a check, you will receive a tax credit when you go to file your 2021 taxes in 2022.
Now, this provides some unique financial planning opportunities for 2021. If you are right around the $75,000 (single or MFS) or $150,000 (MFJ) AGI thresholds, you may want to identify ways to reduce your AGI throughout 2021 so that you would qualify for the (potentially significant!) stimulus checks, especially if you have young kids. Here are some ways how:
- Instead of contributing to a Roth 401(k), contribute to a pre-tax 401(k) for the year to reduce your taxable income. If you are self-employed, you can contribute to a Solo 401(k) or SEP IRA to do the same.
- Enroll in a high deductible health plan that makes you eligible to contribute up to $7,200 into the almighty Health Savings Account where contributions are pre-tax, earnings grow tax-free and withdrawals are tax-free for a qualifying reason.
- Contribute the maximum $5,000 into a Dependent Care Flexible Spending Account if you have access to one through your employer and plan to pay for childcare expenses.
- Fund a Health Flexible Spending Account if you are not on a high deductible plan with a Health Savings Account.
- Defer income (if possible) into 2022 such as a bonus, selling inventory, etc.
These are just a few examples of the planning strategies you can implement. If you are close to the $75,000 (single or MFS) or $150,000 (MFJ) AGI thresholds, then it is crucial to pay very close attention to your income throughout the year. If you are a family of 4, the $5,600 check is a significant amount. You wouldn’t want to inadvertently phase yourself out of it because your total income ultimately exceeded $150,000 from not planning your finances accordingly.
In addition, you could also explore the feasibility of filing taxes separately in 2020 or 2021 if you have one spouse that is making over $75,000, but one spouse making below $75,000. This comes with added complexity (and often slightly higher tax), but it’s worth talking to your CPA about the pros and cons of this in order to potentially receive the stimulus check.
#2) Increased child tax credit
The child tax credit is a way that the government gives you a tax break for having kids under the age of 17. Currently, the child tax credit is $2,000 per child and begins to phaseout once your AGI exceeds $200,000 (single or MFS) or $400,000 (MFJ). This credit directly offsets taxes – so if you have 3 kids, then you receive a $6,000 credit which ultimately reduces one-for-one the tax that you will pay.
As part of the American Rescue Plan Act of 2021, this credit will now increase to $3,000 per child over the age of 6 and $3,600 per child under the age of 6. However, this increased child tax credit is subject to AGI phaseouts just like the stimulus checks. The same AGI phaseouts apply:
- $75,000 if you file taxes single or married filing separately (MFS)
- $112,500 if you file taxes head of household
- $150,000 if you file taxes married filing joint (MFJ)
Again, that $150,000 magical number pops up for a married couple, assuming they file jointly. This means if you are approaching that $150,000 AGI threshold, you want to be very cognizant of how extra income may also affect your child tax credit.
#3) Increased child and dependent care tax credit
If you are working parents and typically pay for dependent care expenses (in addition to the amount used by your Dependent care FSA), then you typically receive a child and dependent care tax credit (different than child tax credit) for 20% of your childcare expenses for up to $3,000 for 1 qualifying child and $6,000 for 2+ qualifying children.
As part of the American Rescue Plan Act of 2021, this credit will now increase to 50% of childcare expenses for up to $8,000 for 1 qualifying child and $16,000 for 2+ qualifying children. But, surprise surprise, this credit is phased out beginning at $125,000 of AGI (regardless of filing status this time…). If you are a single parent earning less than $125,000, then this is a big benefit for you.
On a less favorable note, the “regular” tax credit will now begin to phase out once your AGI exceeds $400,000 which means your tax bill may go up if you find yourself in that AGI level.
In order to qualify for the credit, you must have eligible dependent care expenses and proper recordkeeping.
#4) The temporary removal of the student loan “tax bomb”
Buried in the American Rescue Plan Act is a small, yet substantial provision that impacts young families with federal student loans… the temporary removal of the student loan “tax bomb”. This tax bomb is a result of taxable loan forgiveness which occurs after making 20 – 25 years of federal student loan payments on an income-based repayment plan if you still have a balance remaining at that time. Under current tax law, the forgiven balance is considered taxable income.
However, the American Rescue Plan Act temporarily makes any federal student loan forgiveness tax-free instead of taxable between the years of 2021 and 2025. Now, this won’t impact a lot of people because very few people will be eligible for taxable loan forgiveness during those years since most income-based repayment plans were created in 2007 (which means forgiveness would really start picking up in 2027 – 2032). My educated guess is that this provision will lay the groundwork for a permanent across-the-board removal of the “tax bomb” from federal student loans in the future.
Now, this is only applicable to a small percentage of young families, often in highly indebted professions (medical professionals, lawyers, etc.). However, the financial impact of this could be huge. Here is an example from a client that I previously worked with –
This chart shows:
- Column 1: The net present value of future loan payments in today’s dollars. You can think of this as the cost to write one check today to cover the remainder of all your future student loan payments.
- Column 2: This is the loan balance remaining at the end of the 25 year period of being on an income-based repayment plan. This amount would be forgiven, but considered taxable income.
- Column 3: This is your assumed marginal tax rate which is used to calculate the “tax bomb”.
- Column 4: This multiplies column 2 * column 3 to calculate the “tax bomb” in today’s dollars.
- Column 5: This is the total cost of your loans today which is calculated by adding column 1 + column 4.
- Column 6: This compares column 5 to the cost in today’s dollars to refinance your loans to a private lender with a lower interest rate.
Looking at the above chart, this person would benefit from taxable loan forgiveness compared to refinancing loans and paying down quickly (column 6) even with the added “tax bomb” (column 4) at income levels below $150,000.
Now what happens if you remove the tax bomb?
The net present value of loan payments (column 5) is reduced significantly at income levels between $50,000 and $200,000 which could dramatically change your repayment strategy. Compared to the scenario with a tax bomb, someone making between $150,000 – $200,000 may now be better off going for taxable loan forgiveness instead of refinancing and paying down rapidly.
The overall message here is that there continues to be favorable legislative actions to student loan borrowers. For young families that are carrying over $100,000 of student loan debt, you should certainly understand how this may impact your student loan repayment strategy.
- This was a lot of information, I know. Read it a few times so you can soak it in.
- For some families, it may make sense to purposefully lower your taxable income, postpone income to 2022, or even file taxes separately in 2020 or 2021 in order to benefit from some of the provisions in this act.
- For families with student loans, you should be cheering about the temporary removal of the tax bomb. This may lay the groundwork for a permanent removal of the tax bomb in the future.
- Talk to your financial planner and CPA about how this act impacts you. This is a great reminder how valuable it is when you have a professional that can interpret this act and let you know how it specifically affects you.
None of the information provided is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Experience Your Wealth, LLC does not promise or guarantee any income or particular result from your use of the information contained herein.