The American Rescue Plan Act Is Loaded with Tax Planning Opportunities for 2020 and 2021

Journal of Financial Planning: April 2021

 

Randy Gardner, J.D., LLM, CPA, RLP®, CFP®, is the founder of Goals Gap Planning, LLC, and the director of education for the Garrett Planning Network.

Julie Welch, CPA/PFS, CFP®, AEP (Distinguished) is the managing shareholder of Meara Welch Browne, P.C., an accounting firm in Leawood, Kan.

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On March 11, 2021, President Biden signed the American Rescue Plan Act (ARPA). The Act allocates money for the health crisis, including funds for vaccinations, protective equipment, and the reopening of schools, as well as money for the economic crisis caused by the pandemic. Economic support is directed to businesses and the transportation and restaurant industries, but mainly to individuals in the form of stimulus payments and enhanced tax credits for 2021. Many of our clients can qualify for this relief if they plan carefully.

Economic Impact Payments

ARPA provides individuals with $1,400 ($2,800 for married taxpayers filing jointly) economic impact payments, which are technically advance recovery rebate credits on the individuals’ 2021 tax returns. Taxpayers will also receive $1,400 for each claimed dependent, regardless of age, for 2021. Last year’s economic impact payments applied to dependents under age 17, but the definition of eligible dependents for the 2021 ARPA payments is much broader and includes older high school students, college students, and other relatives who qualify as dependents. The taxpayer claiming the individual as a dependent will receive the $1,400 payment for the dependent.

The recovery rebate credit phases out for single taxpayers with adjusted gross income (AGI) over $75,000 ($112,500 for heads of household and $150,000 for married couples filing jointly). Similar to the previous stimulus checks, people with income above these levels could receive a partial payment or no payment. The phaseout range for the 2021 payments is severely restricted compared to 2020: $75,000 to $80,000 for single taxpayers, $150,000 to $160,000 for married taxpayers filing jointly, and $112,500 to $120,000 for heads of households. 

In general, ARPA uses the taxpayer’s 2019 tax return to determine eligibility. However, if the taxpayer’s income in 2020 justifies a higher economic impact payment, an increased check will be sent to the taxpayer if the taxpayer’s 2020 individual tax return is filed before the later of: (1) 90 days after the 2020 individual tax return filing deadline (normally April 15, but was extended to May 15); or (2) September 1, 2021. Similar to the treatment of the 2020 stimulus payments, if you receive a payment based on 2019 or 2020 income, you will not have to repay the benefit if your 2021 income exceeds the thresholds. Furthermore, those not eligible for payments based on their 2019 or 2020 tax returns but who are eligible based on their 2021 income may claim a refundable tax credit when filing their 2021 income tax returns.

Example: Javier and Maria, a married couple, claim their 15-year-old sophomore in high school, their 21-year-old junior in college, and their 70-year-old relative as dependents. If their income is below $150,000 in 2019 or 2020, Javier and Maria will receive $7,000 (five individuals x $1,400) in economic impact payments. If their income is greater than $160,000 in those two years, they will not receive payments immediately, but they may qualify for the rebate credit on their 2021 tax return if they can keep their 2021 AGI under $150,000. 

Child Tax Credit

For 2021 only, the Act expands the child tax credit in three ways. First, 17-year-old individuals are eligible as qualifying children. For 2020, qualifying children had to be under age 17 to be eligible.

Second, ARPA increases the current $2,000 child tax credit to $3,000 per child ($3,600 for children under 6). With this enhanced credit comes a two-tiered child credit phaseout. The start of the phaseout for the $2,000 child tax credit remains $200,000 for single taxpayers ($400,000 for married taxpayers filing jointly). However, the start of the phaseout for the additional child credit of $1,000 ($3,000 – $2,000, $1,600 for children under the age of 6) is $150,000 of AGI for married taxpayers filing jointly, $112,500 for heads of household, and $75,000 for others. The rate of phaseout is $50 per $1,000 of AGI in excess of the phaseout level.

Example: Scott and Anna are married with three children who are ages 5, 12, and 17. Under 2020 rules, if their AGI was under $400,000, their credit would have been $4,000 ($2,000 for the 5-year-old and $2,000 for the 12-year-old). In 2021, if their AGI is under $150,000, their child tax credit is $9,600 ($3,600 for the 5 year old and $3,000 each for the 12- and 17-year-old children).

If Scott’s and Anna’s AGI in 2021 is $230,000, their child credit is reduced to $6,000 ($2,000 for each child). Their AGI is too high to claim the additional $3,600 credits for 2021, calculated as follows: ($230,000 – $150,000)/1,000 equals 80 reductions of $50 each, or $4,000. The $4,000 phaseout exceeds the $3,600 of additional credits, thereby eliminating them. The phaseout of the $2,000 per child credit does not start until the married couple’s AGI exceeds $400,000. Thus, Scott’s and Anna’s child tax credit is $6,000.      

Third, the child tax credit in 2021 is fully refundable, and half of the credit may be advanced monthly based on 2020 tax information or 2019 tax information, if 2020 is unavailable. The IRS is directed to estimate taxpayers’ child tax credit amounts and pay monthly in advance one-twelfth of the annual estimated amount. Payments will run from July through December 2021. Taxpayers will have the opportunity to opt out of the advanced monthly payments.

Child and Dependent Care Credit

The child and dependent care credit helps working families offset the cost of care for children under 13 and other dependents. ARPA makes the normally non-refundable child and dependent care credit refundable in 2021. This change means taxpayers receive a benefit from the credit, even if they have zero tax liability for the year. 

Furthermore, for 2021 only, the Act increases the expenses eligible for the credit from $3,000 to $8,000 for one qualifying individual and from $6,000 up to $16,000 for two or more qualifying individuals. The credit is calculated by taking up to 50 percent of the amount of eligible expenses, depending on the taxpayer’s income. For 2020, the credit rate was between 20 to 35 percent of eligible expenses, with a maximum value of $2,100 (35 percent of $6,000) for two or more qualifying individuals. For 2021, the maximum credit is $8,000 (50 percent of $16,000).

The Act also significantly increases the income level at which the credit rate begins to be reduced. In past years, the 35 percent rate applied to individuals with AGI under $15,000 but, for this year, the 50 percent credit rate is available to households making up to $125,000 of AGI. In 2020 and prior years, the credit was not reduced below 20 percent, regardless of income. However, in 2021, the Act reduces the credit rate below 20 percent for households with AGI of more than $400,000, which means those with AGI in excess of $440,000 will receive no child and dependent care credit.

Dependent Care Assistance Exclusion

The Act also increases the dependent care assistance plan exclusion from $5,000 to $10,500 ($5,250 for married couples filing separately) for 2021. As long as the employer modifies its plan for 2021, the employee can use the higher limit.

Earned Income Credit (EIC) Changes

ARPA makes several changes to the earned income credit (EIC). First, the credit is allowed for certain separated spouses. Under prior law, married spouses filing separately could not claim the earned income tax credit. The new rule applies only if the taxpayer lived with a qualifying child for more than half of the taxable year and did not have the same principal home as the spouse at least six months of the year. A separation decree or agreement also suffices, as long as the individual did not live with the spouse by the end of the taxable year. This change is permanent and will apply in future tax years as well as 2021.

Second, the EIC for individuals with no children is enhanced. The maximum credit for 2021 is increased to $1,502 from $543. The EIC age range for individuals with no children is broadened to begin at age 19 instead of 25, with the exception of certain full-time students (age 24) and qualified former foster youth or homeless youth (age 18); and the upper age limit of 65 is eliminated. This latter change could be beneficial for some of our older clients.

Other EIC changes include:

  • The credit’s phaseout percentage is increased to 15.3 percent, and the phaseout amounts are increased.
  • The threshold for disqualifying investment income is raised from $3,650 to $10,000 and indexed for inflation.
  • Temporarily, taxpayers are allowed to use their 2019 income instead of 2021 income in figuring the credit amount, if that is more beneficial.

Unemployment Benefits

Federal unemployment insurance payments will remain at $300 for an additional 25 weeks—through September 6, 2021. ARPA also clarifies that the $300 federal supplement will not be counted when calculating eligibility for Medicaid and the Children’s Health Insurance Program.

The Act retroactively excludes up to $10,200 per individual taxpayer ($20,400 for joint filers) of unemployment benefits received in 2020 from taxation for those with AGI under $150,000, regardless of filing status. This exclusion will likely provide much-needed relief to unemployment recipients who did not withhold taxes from their payments or did not set aside funds for the payment of taxes. Eligible individuals who already filed their 2020 tax returns may need to file amended returns.

Example: In 2020, Tina, who is 30 years old and single, received $60,000 in wages and $15,000 in unemployment benefits. Without the exclusion, Tina would report taxable income of $62,600 [$60,000 + $15,000 – $12,400 (standard deduction)] and owe federal income tax of $9,562. With the $10,200 exclusion, her taxable income is $52,400 ($62,600 – $10,200) and her federal income tax is $7,318, a $2,244 tax reduction.

Other Miscellaneous Changes

Family and Sick Leave Credits. Originally enacted by the Families First Coronavirus Response Act, these credits are extended to September 30, 2021, and the limit on the credit for paid family leave is increased to $12,000.

Employee Retention Credit. This credit is extended through the end of 2021 and is now allowed against the Medicare tax.

COBRA Continuation Coverage Credit. Individuals who are eligible for COBRA continuation coverage may claim a premium assistance credit. Under normal circumstances, a person may have to pay at least 102 percent of the cost of the premium for COBRA benefits, but under ARPA, the government would pay the entire COBRA premium from April 1, 2021, through September 30, 2021, for people who have lost a job or had their hours cut. A person who qualifies for new, employer-based health insurance with another employer before September 30, 2021, loses their eligibility for the no-cost coverage. Similarly, an employee who leaves a job voluntarily is not eligible for the free COBRA.

Health Insurance Purchased Through Exchanges. ARPA lowers the cost of health insurance in many instances for people who bought their own coverage through a government exchange. The premiums for those plans will cost no more than 8.5 percent of modified AGI. These changes will last through the end of 2022 and do not require people to re-enroll to access the lower prices. An open enrollment period is in effect through May 15, 2021.

Premium Tax Credits. The Act expands the premium tax credit for 2021 and 2022 by changing the applicable percentage amounts and adding taxpayers who have received, or have been approved to receive, unemployment compensation for any week beginning during 2021 as taxpayers eligible for the credit.

Economic Injury Disaster Loan (EIDL) Grants. ARPA provides that such amounts received from the U.S. Small Business Administration (SBA) and SBA restaurant revitalization grants are not included in gross income, and this exclusion from gross income will not result in a denial of a deduction, reduction of tax attributes, or denial of basis increase—similar to the treatment of Paycheck Program Protection (PPP) loans.

Student Loan Forgiveness. Although the Act did not forgive any student loans, it does include a provision to make any student loan forgiveness enacted between December 31, 2020, and January 1, 2026, tax-free. In other words, if you have been in an income-driven repayment plan for the requisite number of years—or if your school defrauded you—the loan forgiveness will be tax-free.

Rental Assistance. To receive financial assistance, which could be used for rent, utilities, and other housing expenses, the following must be met: (1) household income cannot exceed 80 percent of the area median income; (2) at least one household member must be at risk of homelessness or housing instability; and (3) individuals have to qualify for unemployment benefits or have experienced financial hardship (directly or indirectly) because of the pandemic. Lower-income families that have been unemployed for three months or more will be given priority for assistance.

 President Biden’s goal with the American Rescue Plan Act was to provide much-needed financial relief to individuals, businesses, schools, and governments. During his campaign, he promised many of the individual tax changes included in this Act. Although many of the tax provisions apply for 2020 and 2021 only, there is a good chance the Democratic Congress will make permanent many of the changes described here when they turn their attention to tax policy in the coming months.