Parents: Reap Tax Benefits This Year
CHRISTOPHER GEORGIOU, CPA, MACC, MST
With a price tag of nearly $2 trillion, the American Rescue Plan Act (ARPA) is one of the biggest economic stimulus measures in U.S. history. The legislation offers some significant tax benefits for parents in 2021, including temporary increases in the child tax credit (CTC) and the child and dependent care credit (CDCC) for eligible families. It also provides for monthly advance payments of a portion of the child tax credit starting in July and allows parents to claim the credit for 17-year-olds (previously the cut-off age was 16).
Child tax credit (CTC)
Ordinarily, the CTC is $2,000 per dependent child under the age of 17 (as of the last day of the tax year). The CTC is partially refundable — if your credit exceeds your tax liability, the IRS will send you a check for the difference (up to $1,400), provided your earned income is at least $2,500.
The CTC begins to phase out when a parent’s modified adjusted gross income (MAGI) reaches $200,000 ($400,000 for joint filers). It is reduced by $50 for each $1,000 (or fraction thereof) by which your MAGI exceeds the applicable threshold. So, for example, if you have one qualifying child, the $2,000 credit drops to zero when your MAGI tops $239,000 ($439,000 for joint filers). If you have two qualifying children — for a total credit of $4,000 — those thresholds increase to $279,000 and $479,000, respectively.
For 2021 only, the ARPA increases the CTC to $3,600 for each child under the age of six and $3,000 for each child age six through 17 as of the last day of the tax year (ordinarily, 17-year-olds are ineligible). It also makes the credit fully refundable (for most U.S. residents) and eliminates the $2,500 earned income requirement.
The ARPA establishes two sets of phase-out thresholds for 2021, one of which is notably lower:
- The additional credit amount — $1,000 per qualifying child ($1,600 per qualifying child under age six) — begins to phase out when MAGI reaches $75,000 ($150,000 for joint filers). For example, if you have two qualifying children over age six, the additional credit would be completely phased out at MAGI of $115,000 ($190,000 for joint filers).
- The remaining $2,000 in credit begins to phase out at the pre-ARPA income levels outlined above (MAGI of $200,000; $400,000 for joint filers).
If you are eligible for the CTC in 2021, the ARPA allows you to enjoy the benefits during the year, rather than waiting until you file your return in 2022. Be cautious, however, since you may have to pay all or a portion of this advance back if your income no longer makes you eligible.
Child and dependent care credit
You are eligible for the child and dependent care credit (CDCC) if you pay someone to care for your children (under age 13) or certain other dependents so that you (or your spouse) can work or look for work. Ordinarily, the maximum nonrefundable credit is 35% of up to $3,000 in qualifying expenses ($6,000 for two or more qualifying dependents).
But that percentage is gradually reduced (to a minimum of 20%) if your adjusted gross income (AGI) exceeds $15,000. In other words, except for those with modest incomes, the maximum credit is $600 (20% x $3,000) for one qualifying dependent and $1,200 (20% x $6,000) for two or more qualifying dependents.
For 2021 only, the ARPA makes several modifications to the CDCC, including:
- Increasing the expense limits to $8,000 for one qualifying dependent and $16,000 for two or more.
- Increasing the maximum credit rate to 50% (from 35%) of those expenses.
- Increasing the AGI threshold at which the credit rate is reduced to $125,000 (from $15,000). The rate is reduced by 1% for each $2,000 (or fraction thereof) in excess of the threshold. Thus, the rate drops from 50% to 20% when AGI exceeds $183,000.
- Phasing out the 20% credit by 1% for each $2,000 (or fraction thereof) by which AGI exceeds $400,000, thereby reducing the credit to zero when AGI exceeds $438,000.
To summarize: If your AGI is $125,000 or less, your maximum CDCC is $4,000 for one qualifying dependent or $8,000 for two or more qualifying dependents. The maximum credits gradually drop to $1,600/$3,200 for AGI of $185,001 to $400,000, then gradually drop to zero when AGI exceeds $438,000.
Remember, the enhanced CTC and CDCC are available only in 2021. However, it is possible that Congress will extend these benefits to 2022 or beyond.
Self-Employed Retirement Planning: SEP IRA Versus Solo 401(k)
JOSHUA GOLDSCHMIDT, CPA, MST
Retirement planning can be overwhelming since there is so much to consider. Considerations include:
- The amount to contribute;
- What to invest in;
- What brokerage firm to use to run the account;
- The type of account to open;
- Tax implications of the plan selected; and
- Many other questions to consider.
For self-employed individuals, the first question is often what options are available. Two options available are a Simplified Employee Pension Individual Retirement Account (SEP IRA) and a solo 401(k) plan. Both offer their own set of benefits and restrictions. Having a firm grasp of their differences should help you make a sound decision when selecting your retirement option.
Simplified Employee Pension Individual Retirement Account
A Simplified Employee Pension Individual Retirement Account, referred to as a SEP IRA, is an individual retirement account that can be set up by a self-employed person. A SEP IRA is funded pre-tax. While a SEP IRA provides a deduction for income tax purposes, it does not reduce the amount of self-employment taxes or payroll taxes owed.
SEP IRA accounts work best for self-employed individuals under age 50 that have steady and high net self-employment income or wages. To maximize contributions in 2021, net income from self-employment must be $290,000 or more. For salaried individuals, you can maximize contributions with wages of $232,000 or more.
Benefits of a SEP IRA
- Contribution Deadline
Contributions can be made for the year the plan is to be in effect until the due date (including extensions) of your income tax return. If you are a partner or shareholder in a flow-through entity, the flow-through entity will establish and contribute to the SEP IRA on your behalf. If you file a Schedule C, then the deadline to contribute will be the due date of your individual income tax return.
- Administration Cost
The cost to open and have a SEP IRA is often lower than solo 401(k)s. Because they are easier to manage, some brokerage firms even allow taxpayers to open them online and self-manage their account. Further, there is no annual tax filing for a SEP IRA.
- High Contribution Limit
Contributions a self-employed individual can make to a SEP IRA for 2020 cannot exceed the lesser of 20% of net self-employment income, or $57,000 ($58,000 for 2021). For employees, the contribution limit is 25% of compensation or $58,000 for 2021. If over 50 years old, there is no catch-up provision.
- Employee Contributions
If you have or plan to have W2 employees, you can fund employee retirements. If contributions are made for self-employed individuals, they must also be made for eligible employees. This can be seen as an upside or a downside, as it could make it a cost-prohibitive option for some employers.
Downsides of a SEP IRA
SEP IRAs are funded pre-tax so that distributions will be taxed, including earnings. Further, you have less control of the tax as future tax rate changes are a variable.
- No Borrowing
There is no option to loan yourself money from your SEP IRA.
Solo 401(k) plan
A solo 401(k) is an individual 401(k) retirement plan that is open to self-employed individuals with no employees. You can use the plan to cover you and your spouse, but having a single employee who is not your spouse would make you ineligible to contribute to the plan.
Benefits of a solo 401(k) Plan
- Contribution Deadline
Unlike a SEP IRA, the solo 401(k) plan used to have to be set up by the year-end in which you are contributing. However, the Secure Act now provides that qualified retirement plans adopted after the close of the tax year, but before the due date (including extensions) of the tax return, may be electively treated as having been adopted on the last day of the tax year.
Loans may be allowed for solo 401(k) plans if the plan permits. They are required to be paid back within five years unless they are used to purchase a principal residence. Loans will usually be limited to the lesser of 50% of the vested account or $50,000.
- Contribution Limit
The contribution maximum in 2020 for a solo 401(k) is $57,000 ($58,000 in 2021). Similar to the SEP IRA, you will be limited to 20% of net self-employment income or 25% of compensation and will still be capped at the contribution maximums. However, there is a catch-up contribution of $6,500 a year allowed for participants over 50 years old. This means that the maximum total contribution for 2021 is $64,500 if over 50 years old.
- Elective Deferrals
Participants can contribute the lesser of 100% of compensation or the annual limit of $19,500 in 2021. This would be treated as an elective deferral contribution.
- Higher Contributions with Less Income or Wages
Solo 401(k) plans offer a real advantage over SEP IRA accounts in how much you may contribute even though they share the same IRS limit of $58,000. This is because the solo 401(k) allows for $19,500 in elective deferrals, which are considered employee money. For instance, if your net self-employment income is $150,000, the most you could contribute to a SEP IRA is $30,000, whereas with a solo 401(k) you could contribute up to $49,500. In addition, if you are age 50 or older, you could contribute an additional $6,500 in age 50 catch-up contributions or up to a total of $56,000 to your solo 401(k) plan.
- Roth Contributions
Solo 401(k) plans often allow designated Roth contributions (after-tax). This may be a huge benefit as it protects against future tax hikes and also allows earnings to grow tax-free if not distributed early.
- Investment Flexibility
Some plans now allow a wide variety of investments ranging from traditional stock to new investments such as virtual currency. Not all plans allow the same investments though, so this is something to consider when selecting your plan provider.
Downsides of a solo 401(k) plan
Fees vary from plan to plan, but are often higher for solo 401(k) plans as compared to SEP IRA plans.
- IRS Form 5500 Filing
Once plan assets exceed $250,000, a Form 5500 or Form 5500-EZ will be required to be filed.
There are many items to consider when selecting a retirement plan. To get the full picture of what is right for you, it is usually best to reach out to your ORBA accountant and investment advisor who can help you understand all of the options.