The Child Tax Credit

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By Roy Lewis
November 23, 2001

Did you know that you might be able to claim a tax credit for having kids? That's right -- a tax credit for no reason other than your child is living with you. (I'm sure that many parents will claim that this is reason enough to get some type of tax break.) Let's take a few minutes to look at the child tax credit.

How it works
If your modified adjusted gross income (AGI) is $110,000 or less (for married people filing a joint return), $75,000 (for single or head-of-household filers), or $55,000 (for married/filing separately), then you will be able to claim a credit for any child living with you.

Amount of the credit
Because of the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, the amount of the credit will increase to $1,000 per child over the next few years. Here are the credit amounts that you can look forward to:

2001 through 2004: $600 per child
2005 through 2008: $700 per child
2009: $800 per child
2010 and thereafter: $1,000 per child

Qualifying child
For a child to be deemed "qualifying," the child must have a tax identification number (normally a Social Security number) and must be:

  1. a dependent (or qualified for the dependency deduction);
  2. related to the taxpayer (son, daughter, stepson, stepdaughter, or an eligible foster child);
  3. under the age of 17 as of the end of the year. This means that if your child turns age 17 during the tax year, the child is not eligible for the child tax credit. This is true even if his or her 17th birthday falls on December 31. If the child is age 17 anytime during the year, he or she is not qualified for the credit.
  4. A citizen, national, or resident of the U.S.

So, if your modified AGI is below the limits noted above, and you have a qualifying child, you will receive a credit per qualifying child. Simple as that. No other computations will be required. No other forms to fill out. Also, remember that this is a credit against your tax -- a direct dollar-for-dollar reduction of your actual tax liability. It is not a deduction (which is much less valuable).

Example: Jack and Jill have modified AGI of $65,000 in 2002. They also have three qualifying children. When they compute their taxes, they determine that their total tax liability (before any credits) amounts to $7,200. From this tax liability, they take their child credit in the amount of $1,800 ($600 per child). Their net tax liability is now just $5,400. They also have federal withholding of $7,500. When they apply their withholding against their net tax liability, they'll receive a federal refund of $2,100. For Jack and Jill, the child credit reduced their tax liability by about 25%. That's a pretty big reduction.

The phase-out rules
As with most tax laws, it wouldn't be any fun without some complications. The first one for this law is the phase-out of the modified AGI. If your modified AGI is below the levels noted above (also called the "threshold amounts"), you don't have any problems. But what if your income is greater than the levels noted? Do you simply lose the credit entirely? Not exactly.

The amount of the total credit you can take is reduced $50 for each $1,000 (or fraction thereof) of modified AGI exceeding the threshold amounts. Some simple math will tell you that if you are a head-of-household filer with one qualifying child, your full $600 child credit will be received when your modified AGI is $75,000 or less, and will be completely phased out when your modified AGI is more than $87,000. As the amount of the credit increases from year to year, the phase-out range will also increase. The IRS provides worksheets in the instructions to Form 1040 that can be used to compute partial credit.

Example #1: Mary files as head of household and she has one qualifying child. Mary's modified AGI is $74,000. Mary will receive the entire $600 credit.

Example #2: Same facts as above, but assume that Mary's modified AGI is $78,000. Mary's AGI exceeds the threshold amount by $3,000. To compute how much to reduce the credit, divide the $3,000 by $1,000. That equals 3. Multiply 3 by $50 to get $150 � this is how much the credit will be reduced. Thus, Mary's credit will be $450 ($600 less $150).

Note that the amount of the credit is based on the number of qualifying children, while the phase-out is based on the total dollar amount of the credit. So, the more children you have, the greater your phase-out range. Bottom line: If you have more qualifying kids, you'll also have a larger phase-out range. By way of explanation, let's look at another example.

Example #3: Mary, filing head of household, has two qualifying children and a modified AGI of $90,000. Mary is $15,000 over the threshold, and will be required to reduce her child credit by the $750 ($15,000 divided by $1,000 � 15 � multiplied by $50). But since Mary has two children, she will start with a base credit of $1,200 (2 X $600 credit for each child) and will still receive the benefit of a $450 child credit ($1,200 minus the $750 reduction). In effect, if Mary has one child, her phase-out range is from $75,000 to $87,000. But if Mary has two children, her phase-out range is from $75,000 to $99,000. If Mary had three children, her phase-out range would be from $75,000 to $111,000.

Remember that the child credit rules do not take the place of any other credits for which you may otherwise qualify -- such as the earned income credit or the dependent care (i.e., child care) credit.

Excess credits
The rules get even more complex when your child credits exceed your income tax liability. If so, you may be allowed a refundable credit depending upon your income. This means that Uncle Sammy could write you a check for the excess of the child care credit over your tax liability. The provisions are much too complicated to explain in detail here. Just know that if your credit exceeds your tax liability, you should slog through the child credit rules and worksheets in order to determine if you qualify for the refundable credit. 

As if that weren't complex enough, there's an exception. If you have three or more children and your credit exceeds your tax liability, you can elect to use either the old rules OR the new rules in order to determine the amount of your refundable credit. Again, the rules are much too complex to discuss here. Just understand that if you have three or more children, and your credit exceeds your tax liability, you have even more decisions and computations to deal with.

How do you find out the amount (if any) of your refundable credit? You complete IRS Form 8812 to compute your refundable child tax credit. It's likely, after reviewing the instructions and worksheets for Form 8812, you'll want to write your Congressperson demanding tax simplification. A more painless method of getting your refundable credit amount is to use a computer-based tax-preparation program, and let the program complete the computations for you. If all else fails, and you simply throw up your hands, a qualified tax pro can certainly walk you through this maze. It's not easy, and can be a bit confusing, but the impact of the credit may be well worth the work.

Get your refund now
Many of you will find that this credit generates a very large federal tax refund. While this might make you happy for a short period of time, it's not a good practice. Think about it: It's never a good idea to have Uncle Sammy hold on to your money all year long. Sammy doesn't pay you any interest on those big federal tax refunds. If you will receive a hefty refund, consider revising your federal withholding form for the remainder of the year now. If you anticipate a large refund come tax time next year due to the child tax credit, change your W-4 form now and get that extra cash in your pocket right away.

The payroll department at your place of employment will be able to supply you with a W-4 form and instructions that you can use to revise your federal withholding. Make sure that you get the full W-4 form, the one with the worksheets, so you can make the proper computations. If your employer doesn't have the full W-4 form, you can download it from the IRS website.

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.

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