With the first round of child tax rebate checks going out today, we thought we would revisit this column from Fool tax guru Roy Lewis today. It originally appeared on Fool.com in June.
One of the key provisions in the recently passed Jobs and Growth Tax Relief Reconciliation Act of 2003 is the increase of the child tax credit from $600 to $1,000 per qualifying child effective for 2003. In order to get this additional credit to the tax-paying public early (long before it's time to file 2003 tax returns), Uncle Sam has decided to issue an advance payment check worth $400 for each kid. For example, if you have three qualifying children, you can expect a Treasury check in the amount of $1,200.
But make no mistake: This is an advance against the child tax credit that you'll claim on your 2003 tax return. And it's fraught with possible trouble, misunderstanding, and confusion.
Remember just two summers ago when most of us received either $300 (for single folks) or $600 (for married taxpayers) as a "rebate" against lower taxes in the following year? If so, you'll likely also remember that you had to reconcile the payment that you received when you prepared your 2001 individual income tax return. That money wasn't free -- it was simply an advance against lower taxes in the future.
The child tax credit advance payment is similar, with some potential pitfalls.
Child tax credit advance payments
The IRS will send notices to taxpayers on July 23, July 30, and Aug. 6, informing each taxpayer of their advance payment amount. The Treasury will then mail checks on July 25, Aug. 1, and Aug. 8 to taxpayers who filed their returns by April 15. The checks will be issued based on the last two digits of the Social Security number listed first on the 2002 tax return. Taxpayers whose last two digits are the lowest will receive their checks first.
If you've filed for an extension for your 2002 tax return and are eligible for the advance child tax payment, you'll get your check four to six weeks after the IRS receives your 2002 tax return.
Both the notice and the check will be mailed to the address listed on your 2002 tax return. Anyone who has moved since filing the 2002 return should notify the U.S. Postal Service of the new address, so that the notice and check will be forwarded.
If an advance payment check cannot be forwarded to you (because of an address snafu), it will be returned to the IRS. But even if your check is returned to the IRS, you'll still be able to claim the full child tax credit of up to $1,000 per qualifying child on your 2003 tax return. You'll just have to wait until early 2004 (when you file your 2003 return) to get that additional credit in your pocket.
What pitfalls?
Everything sounds very groovy so far, right? You'll open your mailbox and receive a check. What could be easier? For many of you, that'll be exactly the case. But for others, the problems could be numerous. Why? Because the IRS is a year behind with its information.
The IRS is using your 2002 tax data to figure the advance payment. Some of you will have a much changed tax situation in 2003, the year for which the credit is really applicable. Thus, it is important that you keep track of the advance payment notice that you receive in order to reconcile that payment on your 2003 individual income tax return.
So if you're one of the folks receiving this $400 (or more) payment, make sure to keep good records on the amounts, since you'll be revisiting this information when you prepare your 2003 return. And this is the case regardless of if you prepare your return of if you use a tax pro. Treat the IRS notice of your advance payment like you would your W-2 form or your mortgage interest statement.
So, other than the additional bookkeeping, what are some of the other pitfalls? Glad you asked.
Qualifying child in 2003: If a new addition to your family was born (or adopted) in 2003, you won't receive a $400 check. That's because the IRS is using your 2002 tax data. Instead, you'll have to wait until you file your 2003 return in order to claim the full $1,000 child tax credit for your little bundle of joy and odor.
Loss of dependent: How about your child that qualified for the child tax credit in 2002 but will not be a qualifying child in 2003 (because of age, death, income, or any other reason)? The IRS doesn't know that this child won't qualify for the credit in 2003, and you'll likely receive a $400 advance payment check. Don't spend it all in one place, since you might have to give that $400 back in the form of a reduced credit for another child when you prepare your 2003 return.
Increased income: Let's say that you had four qualifying children in 2002. You'll receive a check for $1,600 in just a few short weeks. But luck has shined on you: You won the lottery in 2003... or otherwise increased your income! Uncle Sam has no idea that you'll not be able to claim the child tax credit in 2003 (due to the income phase-out rules).
You might think that you'd have to give this advance back to Uncle Sam, but your luck keeps getting better and better. A provision in the law states that while the advance payment will reduce any child tax credit that you can claim, it will not reduce the credit below zero. So in this case, it appears that you'll be able to keep the entire $1,600 in advance payment, and you'll not have to reduce your refund or increase your taxes due. Sure, it seems odd -- but that's the way the law appears to be currently written.
Decreased income: Take the above case in reverse. Say that you have four qualifying children, but you weren't able to claim the child tax credit for 2002 because of your high income level. Uncle Sam won't know that you had a business reversal in 2003 and that your reduced income will allow for the child tax credit for all four of the kids. Don't expect an advance payment in the amount of $1,600. You'll have to wait until you file your 2003 return in order to receive the credit.
Alternating dependent: This could be the most complicated of all of the situations regarding the advance child tax payment. Some divorced taxpayers alternate years in which they claim dependents on their tax return. Since you can't take a child tax credit without a dependent exemption, they also alternate the benefit of the credit. So if you were allowed to claim the dependent in 2002, but you have agreed that your "ex" will claim the dependent in 2003, you'll receive the advance payment check for $400.
But it's not yours. You'll have to give it back when you file your 2003 tax return. And your ex will not receive the $400 advanced payment, and won't get the benefit of the full credit until the 2003 return is filed.
The good news is that the IRS recognizes this potential problem. The bad news is that they have no procedures to correct this problem as of this time. What should you do? I think I'd simply hold onto the refund check for a few weeks in the hope that IRS will provide guidance or procedures that will address this situation.
But what you should not do is "sign over" the refund check to the ex that may be receiving the credit for 2003. It's likely that you'll still have to give back the $400 when you prepare your 2003 tax return. No use adding insult to injury when you ex has your $400, and receives the benefit of the full $1,000 child tax credit for 2003.
Act now
So while most of the news is good, there are some potential problems. If you find yourself in a situation where you might have to give back your $400 advance payment, deal with it now. Mid-year tax planning has never been more important.
And if you don't receive your advance payment but will expect to claim the full credit when you file your 2003 return, don't wait until early 2004 to receive the benefit of lower taxes. Instead, review your withholding status and consider claiming greater dependent exemptions now in an attempt to reduce your 2003 refund. No use giving Uncle Sam an interest-free loan. So consider reviewing your current W-4 form and making changes as necessary.
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.
