The coronavirus-relief legislation signed by President Biden earlier this month contains unprecedented benefits for families with children and other dependents -- especially for some who plan carefully.
The new benefits, which apply for 2021, are largest for low-income families, but they extend well into the middle class, with many eligible for more than $10,000 in tax-free income for this year. Higher earners can also benefit from some changes, such as expanded tax breaks for child-care costs.
The design of these provisions creates powerful incentives for many families to pay close attention to their 2021 adjusted gross income. Some of this year's best benefits phase out above certain income thresholds: $150,000 for married couples filing jointly, $112,500 for head-of-household filers, and $75,000 for single filers.
As a result, people who are likely to earn above the limits may want to legally reduce this year's income to fit within them, and those normally earning less may want to prevent an income spike that could cost them dearly.
Here's a real-life example of how the limits can drastically affect a family's finances. Patrick and Laura Peterson live in Aston, Pa., and have four children, ages 2, 3, 5 and 8. Last year Mr. Peterson, a bank manager, took a $33,000 taxable Covid withdrawal from his retirement plan as an emergency cushion. That boosted their 2020 income high enough above $150,000, to disqualify them from six third-round stimulus payments of $1,400 after Mr. Peterson filed their 2020 tax return in early February.
Because the Petersons' income will drop well below $150,000 this year, they'll be able to claim those rebate credits worth $8,400 when they file their 2021 tax return next year. They'll also likely get full extra child credits of $5,200 that would be clipped if their income were higher, bringing them $13,600 of tax-free income this year from these new breaks.
"I have four children, a mortgage and two car payments. My wife is a nurse. We need these benefits, and I didn't want to miss out because of a Covid withdrawal," says Mr. Peterson.
For those earning above the thresholds for 2021, there are still benefits. The new law more than doubles the usual $5,000-per-household annual limit on pretax contributions to employer-sponsored dependent-care Flexible Spending Accounts this year. It also includes a complex expansion of the child-and-dependent-care tax credit.
Here's information to help maximize the new 2021 tax benefits for families.
Understand the third-round stimulus payments.
For many families the most generous 2021 benefit is the third-round stimulus payments or rebate credits up to $1,400 per household member, even for older children and adult dependents.
The Internal Revenue Service is sending payments now, but people who aren't eligible based on 2019 or 2020 income and do qualify based on 2021 income can get rebate credits for these amounts next year through their 2021 tax returns.
Know the other child-related changes this year.
The extra child tax credit is up to $1,600 per child under 6 and $1,000 per child under 18 at year-end. This is in addition to the existing child credit of up to $2,000 per child, which this year applies to dependents who are under 18 at year-end, versus under 17 in other years.
Starting July 1, taxpayers may receive advance payments of part of these benefits from the IRS. Details haven't been announced.
Workers with employer-sponsored dependent-care FSAs can contribute up to $10,500 of pretax income to pay care expenses in 2021, versus $5,000 normally. The employer must opt into this change, but many are expected to.
The child- and dependent-care credit has also been expanded so that up to $8,000 of expenses are covered for one dependent (up from $3,000) and up to $16,000 are covered for two or more (up from $6,000).
For stimulus payments and rebate credits, the phase-out is steep. The range is $150,000 to $160,000 for married joint filers; $112,500 to $120,000 for head-of-household filers; and $75,000 to $80,000 for single filers.
For this year's extra child credits, the taxpayer loses $50 of credit per $1,000 of income above the phaseout starting point. Thus a couple with $200,000 of income, four children and $5,200 of extra credits would lose $2,500 of credits due to the phase-out. For the existing child tax credit, the phase-out still begins at $400,000 for joint filers and $200,000 for single and head-of-household filers.
Dependent-care FSA contributions don't have income limits other than the lower-earning spouse's earned income. So if one spouse earns, say, $5,000, then the couple can't put more into the FSA. Employers must also ensure that plans don't favor higher earners too much.
The 2021 child-and-dependent-care credit has a complex phase-down of the rate and phase-out based on income. According to Melissa Labant, an attorney and CPA with the accounting firm CLA, the credit phases down from 50% to 20% of expenses for most joint filers with incomes between $125,000 and $183,000. Above $183,000 the rate is 20% until $400,000, and then the rate drops until the break is fully phased out at $438,000.
Know what income counts -- and what reduces it.
The income thresholds are for "modified adjusted gross income," but for most filers that means their AGI on Line 11 of Form 1040. Beware: AGI is not reduced by itemized deductions, such as for mortgage interest or charitable contributions, or by tax credits.
What does reduce AGI? Contributions to retirement plans such as 401(k)s; tax-deductible contributions to IRAs and SEP IRAs; pretax contributions to health savings accounts; and pretax contributions to medical or dependent-care flexible spending accounts, among other things. A married couple under age 50 could reduce their AGI by more than $50,000 by making maximum 401(k) and flexible-spending-account contributions for 2021.
If a filer reports self-employment income on Schedule C, business deductions could also reduce AGI.
Revisit FSAs versus Child- and Dependent-Care Credits.
In prior years many higher-bracket taxpayers with two or more children benefited from maxing out dependent-care FSAs and then taking the dependent- and child-care credit for remaining eligible care expenses. Expenses can be claimed only once.
The expansion of the 2021 child-and-dependent-care credit complicates this analysis. However, FSA contributions retain the advantages of not being subject to payroll taxes or, in many cases, state taxes.
Figuring which benefit is most valuable at what income levels can be hard, says Ms. Labant, especially because some states have care credits as well.
By her rough calculations, many married joint filers with incomes of $150,000 or less will benefit more from the child-care credit, while those earning above $160,000 typically should look first to the FSA. But many filers will need to run the numbers to find out.
She adds: "Maybe these parents have children that can double-check their math."