Understanding Tax Credits When You Have Children

There are many reasons that divorcing or separating parents argue over custody of their children. While gaining a tax advantage may not be the primary reason to seek custody of a child, historically, there have been federal tax benefits associated with having a child. For example, the parent who had a child living with them more than half the time could claim the child as a dependent on their tax return. The Tax Cuts and Jobs Act (TCJA) of 2017 changed that particular benefit by eliminating personal exemptions. However, there is a child tax credit divorced parents may seek to benefit from, as well as other tax credits associated with children.

Many parents pay more in taxes than they need to because they are unaware of the child tax credit and other tax credits. With the sweeping changes in federal tax law created by the TCJA a few years ago, as well as those recently implemented by the American Rescue Plan in 2021, you should know about tax credits that can lighten your income tax burden, especially after a divorce.

What’s the Difference Between a Tax Credit and a Tax Deduction?

Before we dive into a discussion of the various tax credits available to parents, let’s take a moment to clarify the difference between a tax credit and a tax deduction. A tax credit is applied directly to the amount of tax you owe. If your income tax due equals $3000, but you have a $2000 tax credit, you will only have to pay $1000. In other words, a tax credit reduces your taxes dollar for dollar. A tax deduction reduces the amount of income on which your tax is calculated. If you have $50,000 in income with a $5,000 tax deduction, your taxable income will be $45,000.

While both tax deductions and tax credits reduce your taxes, tax credits are usually more beneficial. Some tax credits are refundable, meaning that if the amount of the tax credit is more than the amount you owe, the government will give you the difference back as a tax refund. For example, if your tax bill is $900, but you have a $1400 refundable tax credit, you will receive a $500 income tax refund.

Earned Income Tax Credit (EITC)

The Earned Income Tax Credit (EITC) is considered by many to be one of the most successful anti-poverty measures in the United States. It is designed to help individuals with low to moderate income levels by raising the annual income of working households. The size of the credit depends on the amount of income from paid employment and household size. You don’t have to have a child to claim the EITC, but, the more children you can claim on your tax return, the larger the EITC you may qualify for. The EITC is a refundable tax credit.

To get the EITC for tax year 2021 (for which you will file in 2022), you must:

• Have at least $1 of earned income (not pensions or unemployment) but be below applicable income limits;
• Have investment income of $10,000 or less (that number increased for tax year 2021; previously, it had been $3,650 or less);
• Not have to file IRS Form 2555 (Foreign Earned Income) or Form 2555-EZ (Foreign Earned Income Exclusion).

For tax year 2021, the earned income credit ranges from $1,502 to $6,728 depending on your filing status and how many children live in your household. Under some circumstances, you may be able to claim the credit if you are separated but not yet divorced. You may also be able to claim the credit for 2021 based on either your 2021 or 2019 income. Ask your tax preparer to calculate which is better for you.

The Minnesota Working Family Credit is a state tax credit that is similar to the federal EITC. If you qualify for the EITC, you may qualify for the Minnesota Working Family Credit as well.

Child Tax Credit (CTC)

President Biden’s 2021 American Rescue Plan (ARP) made some major changes to the federal Child Tax Credit (CTC), and is estimated to have lifted millions of children out of poverty. Prior to the ARP, parents could receive up to $2,000 in tax credit for each dependent child under the age of 17.

Under the ARP, the Child Tax Credit:

• Has become available to more low-income families;
• Is fully refundable;
• Has increased from $2,000 per child in 2020 to $3,600 per child under the age of 6;
• Has increased from $2,000 per child in 2020 to $3,000 per child who is older than 6 but younger than 17;
• Has made 17-year-olds eligible for the $3,000 credit for the first time;
• Got money to families sooner by sending monthly payments of up to $300 per child under 6 and $250 per month for older children starting in July 2021; parents will get the remainder when they file their taxes in 2021.

Under the ARP, even families who do not need to file taxes can receive the CTC, which is fully refundable. The CTC will also not affect a family’s eligibility for means-tested benefits. There is an income limit for eligibility, but the great majority of American families will be eligible for the CTC.

One important note: the above changes to the CTC were a response to the COVID-19 pandemic and are only in place for tax year 2021, though some politicians want to make the changes permanent.

Child and Dependent Care Credit

The Child and Dependent Care Credit is designed to help pay for the care of eligible children and other dependents, such as elderly parents. The amount of the credit depends on your income and a percentage of your expenses for the care of dependents so you can work, seek work, or attend school.

The ARP increased the amount of the credit for 2021, making it much more generous: up to $4,000 for one qualifying person and up to $8,000 for two or more qualifying persons. Depending on your situation, the credit may also be refundable. The expansion of this credit is making it available to many Americans for the first time, so even if you have not been able to claim this credit in the past, ask your tax preparer if you are eligible in 2021.

Minnesota Education Credit and Subtraction

Minnesota also offers two tax relief programs for families who have a qualifying child attending kindergarten through 12th grade and who have paid “qualified education expenses” for that child’s education during the year. Eligible families may have a child in public or private school, or even a qualified home school. The Minnesota Education Credit and Subtraction offer relief from Minnesota state income tax.

Don’t leave money on the table at tax time because you didn’t know that you qualified for a tax credit. If you have questions about how divorce will affect your taxes, please contact Mundahl Law to schedule a consultation.