Chances are you’ve heard about the child tax credit. Aside from the name, most Americans don’t know how it works, who qualifies, and how it helps you save money. Understanding these tax credit basics can help you make smarter financial moves and, hopefully, get ahead financially.
What Is The Child Tax Credit?
The Child Tax Credit started in 1997 with the Taxpayer Relief Act. At the time, the credit was for $400 per child under the age of 17. The value increased to $2,000 per child as of 2020. In 2021, President Biden signed the American Rescue Plan Act, which increased the amount of the credit.
Families could take a credit of $3,600 per child under 6 years old and $3,000 for each child ages 6-17. In addition to the increased amount, families could elect an advance payment from July through December.However, the law was only applicable for one year. As of 2022, the child tax credit reverted to $2,000 per child, and the monthly payment went away.
It is important to note there is an income phase-out for the credit. Single filers with a modified adjusted gross income (MAGI) of $200,000 or less get the full credit. For joint filers, you need a MAGI under $400,000. Income over these limits reduces the credit by $50 for every $1,000.
While it is disappointing the increased tax credit was only around for one year, families can still take advantage of the smaller credit. Additionally, 16 states are enacting a state-level child tax credit to help residents of their states.
Here are the best uses of the credit you earn, either from the state, federal government, or both.
Ways To Use Your Child Tax Credit
Before getting into the best uses of the child tax credit, it is important to understand why the credit is such a powerful savings. The reason is the difference between a tax credit and a tax deduction.
Credits vs. Deductions
A tax credit is a dollar-for-dollar reduction in the tax you owe. For example, if you paid $5,000 in income taxes and have one child, you would reduce your tax liability by $2,000. Assuming no other income or deductions, in this case, you would receive a refund check for $2,000.
A tax deduction, on the other hand, is a percentage reduction of your tax liability based on your income tax bracket. Student loan interest is an example of a tax deduction. If you paid $8,000 in student loan interest during the year and are in the 25% tax bracket, you can deduct $2,000 from your taxable income. You cannot deduct the entire $8,000, only the amount that is proportional to your income bracket.
Now that we’re all on the same page about tax credits, here are the best ways to use it.
A straightforward way to use the child tax credit is to save it. According to the Federal Reserve of St. Louis, the personal savings rate is just 5%. This means on a salary of $50,000, the typical American is saving $2,500 a year.
These savings could be going towards retirement, emergency savings, short-term savings goals, or to cover irregular bills. With studies showing that 60% of Americans have less than $500 in savings, many of us are living on the edge of disaster.
We all know life happens: Your car breaks down or you need a new hot water heater. If you don’t have money set aside for these unexpected expenses, you will have to go into debt. Once you start the debt cycle, it isn’t easy to dig out.
While it isn’t the most exciting thing to do with your money, putting it into a high-yield savings account might make the most sense.
Investing your money for the long term is a smart financial move. When you invest your money, it goes to work for you, growing in time thanks to compound interest. If you were to put $2,000 in the stock market for 30 years and earn an average of 8% annually, you would end up with over $20,000.
Even better, take the $2,000 and invest it every year for 30 years. In this example, you end up with close to $265,000.
The only question left is where to invest your money. Q.ai has many different investment kits that you can choose from based on your risk tolerance, time horizon, and preferences.
Pay Down Debt
According to the Federal Reserve, the average household debt sits at over $165,000. This figure includes credit card debt, mortgage debt, student loans, and auto debt.
If we exclude mortgage debt, the average household debt is close to $52,000. This puts a lot of stress and pressure on family finances. Not only do you have the monthly payment, but if this is high-interest debt, that accruing interest is making it harder to dig out of the hole.
By putting your tax credit refund towards your debt, you can make a sizable extra payment and save money on interest. At the very least, you should take a large percentage of the money and put it towards your debt. For example, if your refund is $2,000, take 80%, or $1,600, and put that towards your debt. You can spend the remaining $400 as you like.
Use It For Living Expenses
In an ideal world, you would use the tax credit to boost your savings or knock down debt. But the reality is that inflation is high, and the cost of everything you buy is increasing.
While the monthly CPI reports show inflation is slowing, it is still abnormally high. Digging deeper into the reports shows that most categories, like rent and food, continue to have price increases. It is just that the price of gas has declined so much it has offset the other gains.
Because of this, many families will have to use the tax credit on daily expenses. If this is you, it can be frustrating not to use the money to get ahead. But all hope is not lost. You can review your household expenses and see if there are cuts or other reductions you can make.
If you take action now to lower some of your monthly bills, you may be able to use a portion of the tax credit for investing or paying down debt and not all of it for living expenses.
The child tax credit has been a significant success in helping families make life more affordable. Unfortunately, the increase in the tax credit expired at the end of 2021, and unless Congress acts, it won’t be coming back. Still, getting a credit of $2,000 per child is a substantive benefit and if you live in a state that has enacted a state-level child tax credit, you will be able to claim this as well.
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