The American Rescue Plan Act (ARPA), enacted to provide economic relief to people adversely affected by the Covid-19 pandemic, has some provisions that warrant attention and planning. Under certain circumstances, some income could have a high marginal rate. Careful attention to the Act may help people be aware of the possible tax pitfalls.

Income Tax Rates Effects 

The Child Tax Credit has been enhanced for 2021 due to the enactment of the ARPA. Let’s take a look at an example of how the ARPA may impact some families’ income tax rates and tax credits. John and Kathy, who make $150,000 in combined income, have two children under the age of six (note that the Child Tax Credit is reduced from $300 per month to $250 for children ages 6-17).

John and Kathy pay for child care using an employer-sponsored Flexible Spending Account (FSA). If they had paid for child care using their own after-tax money, they could have claimed an additional credit—the Child and Dependent Care Tax Credit (CDCTC). This credit was expanded by the ARPA to allow a tax credit of 50% of eligible child care expenses to a maximum of $4,000 for families with one child and $8,000 for families with two or more children.

The CDCTC is phased out beginning at incomes over $125,000, and is fully eliminated for incomes over $400,000. In this example, Michael and Joanna are in the same situation as John and Kathy, except they make an extra $10,000.

The following table illustrates the difference in possible taxes due that this additional income may cause.

The examples provided in this publication are hypothetical in nature and do not consider your particular circumstances. Please consult with a tax advisor for tax advice specific to your situation.

 Example A: John & KathyExample B: Michael & JoannaDifference
Gross Income$150,000$160,000$10,000
Above the Line Deductions:   
Adjusted Gross income$150,000$160,000 
Standard Deductions$25,100$25,100 
Taxable Income$124,900$134,900 
Tax$18,975$21,175$2,200
Credits:   
Economic Impact Payments ($5,600)0 
CTC($7,200)($6,700) 
Net Tax Liability$6,175$14,475$8,300

Understanding the Implications

In this example, the additional $10,000 of income increased the tax that Michael and Joanna would have to pay by $8,300 for a marginal tax rate on this income of 83%. If they had more than two children, the effect of eliminating the stimulus credit would be even more dramatic (because each family member’s $1,400 stimulus would be eliminated), and the marginal rate could even exceed 100%. Also, if they paid for child care using after-tax dollars, the CDCTC would have been further reduced by the additional income.

The reason for this hypothetical result is that several of the relief provisions are structured as tax credits, rather than rate reductions or additional deductions. Credits are generally seen as fairer to lower income taxpayers because the tax benefit if you are eligible is a dollar-for-dollar reduction in your taxes. In other words, a $1,000 credit gives a low income taxpayer the same break that a higher income taxpayer would receive. And, because tax credits are a direct reduction in taxes, these are more valuable than a deduction (which reduces taxable income against which a rate is multiplied to determine the tax liability). However, in the case of credits—which are reduced for income above a certain level—the opposite will be true; the tax increase resulting from a small increase in income will be taxed at an unusually high level.

Refundable Credit 

The most significant tax break that Congress can create for a taxpayer is referred to as a “refundable credit.” These are amounts that the IRS will pay a taxpayer even if the taxpayer has never paid any money at all to the IRS. The Economic Impact Payments provided under the ARPA are refundable credits (as were the similar payments made during 2020).

The previous Coronavirus relief laws provided a phase out of the stimulus payment, which is much more gradual than what the latest law allows. ARPA provides the third round of stimulus payments. For example, under the law passed last spring, a family of five with an Adjusted Gross Income (AGI) under $228,000 received a payment. In the next round, a family of five with an AGI for 2019 of $210,000 or less received something. However, under the ARPA, a family of five with an AGI over $160,000 will receive no payment. When the phase out curve is so steep, the tax arithmetic can become complex.

Strategies to Consider 

As our example illustrates, people who expect income for 2021 that is close to, or slightly over, the level where phase outs begin should carefully plan strategies that will allow the available credits to be used to their fullest.

In our example, one approach might be for Michael and Joanna (in the example provided) to defer some income into 2022 or years beyond. The best way to do this will depend on individual circumstances, and taxpayers should consult with a qualified tax advisor to avoid “constructive receipt” problems that might arise if deferring income is not properly planned.

Another idea would be for Michael and Joanna to generate some “above-the-line,” or non-itemized, deductions such as increasing contributions to 401(k) plans or traditional IRAs. Also, taxpayers should carefully consider delaying a Roth conversion to 2022 if doing so this year will cause a loss of the special tax credits.

In the example, both John and Kathy Michael and Joanna claim the standard deduction on their taxes rather than itemizing deductions. Since the standard deduction was almost doubled by the Tax Cuts and Jobs Act of 2017 (TCJA), many more taxpayers have been using the standard deduction. However, greater deductions may be possible for taxpayers who itemize deductions. Although TCJA limited the state and local tax that can be deducted to $10,000, generous limitations still exist for people who deduct charitable contributions.

One approach that Michael and Joanna might consider is whether to “bunch” several years of charitable giving into 2021 by opening a donor advised fund (DAF). Funds that are contributed to a DAF can all be deducted in the year in which the contribution is made.

However, the contributions to the charities can be spread over multiple years. If someone has a practice of donating $5,000 annually to their alma mater, they might make a $20,000 contribution to a DAF in 2021 and make their gift for the next four years from that account. Under the right circumstances, the tax credits that are saved could pay for a substantial portion of this gift.

Some of the planning needed to avoid the complexities or downfalls created under the new law will take some time to evaluate and implement. It’s important that you consider your unique needs and circumstances, consult your tax advisor, and contact us with any questions or concerns.

By establishing a relationship with us, we can build a tailored financial plan and make recommendations about solutions that are aligned with your best interest and unique needs, goals, and preferences.

Contact us today to discuss how we can put a plan in place designed to help you reach your financial goals.

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All information relating to COVID-19 or the American Rescue Plan Act is based on the most current information we have as of the date of publication, March 18, 2021. As such, the positions stated herein do not constitute legal, tax, or accounting advice. Please visit https://www.irs.gov/coronavirus for the most current information from the IRS for application to your particular tax situation. This piece does not address the question of what individuals personally should or should not do in response to the Coronavirus COVID-19 or the ARPA. Depending on when you’re reading this content, there may be more current information available. Please contact your Financial Advisor to discuss your specific situation.

Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

The examples provided are all hypothetical and do not take into account any specific situations. The hypothetical examples are provided to help illustrate the concepts discussed throughout and do not consider the effect of fees, expenses, or other costs that will effect investing outcomes. Any actual performance results will differ from the hypothetical situations illustrated here. Please consult a professional to help you evaluate your situation before implementing any of the strategies discussed here.

 

About the author

Michael Repak

Vice President & Senior Estate Planner

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