In 2021, the percentage of Americans who paid no federal income tax increased to 57% in comparison to 44% pre-pandemic. Covid relief efforts such as the American Rescue Plan Act played a large part in this change.
The American Rescue Plan Act was passed in the early part of 2021. Inside that bill, there were stimulus payments and changes to tax credits for individuals and families. Let’s dive deeper to understand these tax law changes and their impact.
To understand the law changes, we must first discuss what a tax credit is. A tax credit is a dollar-for-dollar tax reduction to your final tax liability. Meaning that if you get to the bottom of your 1040 and it says you have a tax liability of $10,000 but have a tax credit of $2,000, your final tax liability would be $8,000. You likely paid this tax liability throughout the year by having your employer withhold taxes.
Tax credits can be refundable or non-refundable. A non-refundable tax credit can bring the tax liability you owe down to zero but never negative. In other words, the IRS won’t write you a check for non-refundable tax credits. However, a refundable tax credit can decrease your tax liability past zero and even negative; this ends in you owing zero in federal taxes and the government actually paying you. Tax returns with negative tax liabilities were much more likely in 2021 due to the covid relief efforts.
Over the past two years, if we had a dollar for every time we heard the word “stimulus”, every American would be retirement-ready today.
Congress passed the American Rescue Plan Act (ARPA) in early 2021, which provided stimulus payments to be sent out to millions of taxpayers. Most people saw the $1,400 stimulus payment as a check from the government. But really, the stimulus payment was a refundable tax credit the government advanced to taxpayers. That means if you were eligible for a stimulus payment in 2021, but did not receive it, it would be applied to your tax return.
The ARPA stimulus payment was paid out as $1,400 to any adult and dependent. This means a family of five, consisting of two adults and three kids, would have received either a $7,000 stimulus check or a $7,000 refundable credit upon filing a tax return
An income phaseout is applied to this stimulus payment. Anyone filing their taxes as single with an adjusted gross income of over $75,000, or married with an adjusted gross income of over $150,000, would’ve received a reduced stimulus payment or even no stimulus payment at all.
Additionally, the ARPA changed the child tax credit for 2021. Normally, the child tax credit is $2,000 per child under the age of 17. The only limitation is income. The credit is available in full if you are a single filer with income less than $200,000, or married filing jointly (MFJ) with an adjusted gross income is less than $400,000. For example, if you are MFJ, make less than $400,000, and have three kids under the age of 17, you would likely receive a $6,000 tax credit, helping lower your end-of-year tax liability.
The ARPA changed this tax credit some. The bill added an extra $1,600 for each child younger than six and $1,000 for children between the ages of six and 16. But the additional tax credit of either $1,600 or $1,000 began to phase out at $75,000 for single filers and $150,000 for MFJ couples. For example, let’s go back to our hypothetical family with three kids. Let’s say two kids were under the age of six and one was older than six. Let’s also say the family had an adjusted gross income of $100,000. Their child tax credit would be $10,200. That compares to $6,000 previously. In other words, the family was able to receive an additional $4,200 in tax credits in 2021.
But that’s not all.
The Child Dependent Care Tax Credit (CDCTC) was also modified for 2021. The CDCTC is designed to help families pay childcare expenses for kids under age 13 so that parents are able to work. If you qualified for this credit, you likely noticed a drastic change to the tax credit you received. Previously, the maximum CDCTC was $2,100, which was a non-refundable tax credit. After ARPA, the maximum credit soared to $8,000 and was turned into a refundable tax credit. Remember, a non-refundable tax credit can only be used to take your tax liability to $0, while a refundable tax credit can be used to create a negative tax liability with a check to you from the IRS.
Now if we look at our fictional family of five making $100,000, used in the above examples, what would their tax bill have looked like in 2021?
The family received a total stimulus payment credit of $7,000, a child tax credit of $10,200, and dependent care credit of $8,000. Adding those items up, the family earned a whopping tax credit of $25,200 in 2021.
Let's take it one step further.
Before credits, this hypothetical family would have owed roughly $8,500 in federal income taxes. After applying tax credits, however, the IRS would have owed them $16,700. Keep in mind, that without any tax credit changes from the ARPA, this family would have received $8,100 in tax credits and still owed federal income tax of roughly $400 to the federal government. So ARPA made a difference of over $17,000!
Breaking down each of those tax credits highlights how the percentage of American households that did not pay federal income taxes jumped from 44% in 2019 to 57% in 2021.
ARPA made a huge difference for many families.
Justin Lueger is President of Invisor Financial LLC, a registered investor adviser firm in the State of Kansas. All opinions expressed are his own and should not be viewed as individual advice. He can be reached at justin.lueger@invisorgroup.com.