By Kyle Pomerleau

Earlier this month, Politico reported that the expanded child tax credit (CTC) could impact tax refunds this filing season. Some may see larger refunds compared to filing season 2021, while others may be surprised by a smaller refund or even a balance due.

Here’s how it could happen.

The American Rescue Plan Act (ARPA) temporarily expanded the
CTC from $2,000 per child to $3,000 per child ($3,600 for young children). Households
with children received half of their credit in six equal monthly advance
payments from July 2021 through December 2021 and can receive the rest of the
credit when they file their taxes this year. Households had the option to opt out
of the advance payments and receive the entire credit during filing season.

The ARPA CTC could reduce refunds for households that
received monthly advance payments. Consider a hypothetical married couple that
claims two children and files jointly. For tax year 2020, this couple earned
enough to put their pre-credit income tax liability at roughly $8,500, and they
received a CTC of $4,000 ($2,000 per child), resulting in an after-credit
income tax liability of $4,500. Suppose each spouse set up their income tax withholding
to jointly total $6,500 by the end of the year. As a result, they received a
refund of $2,000 after filing their taxes because their total amount withheld of
$6,500 was greater than their federal income tax liability of $4,500.

For tax year 2021, suppose this couple kept their income tax
withholding the same and expected to have the same pre-credit tax liability as 2020.
They qualified for the larger CTC, did not opt-out of the advance payments, and
as a result, received $500 each month from July 2021 through December 2021 for a
total of $3,000. The larger credit reduced their after-credit tax liability
from $4,500 to $2,500, and their withholding effectively fell from $6,500 to
$3,500 due to the CTC advance payments totaling $3,000. Despite the $2,000 tax
cut, their refund was cut in half to $1,000.

This is just one hypothetical example. Under certain
circumstances, a tax filer may end up owing money at tax time when they
normally receive a refund. If the couple discussed above had withheld $5,000
and received a $500 refund last year, they would end up owing $500 this year. Alternatively,
if this couple opted out of advance payments or reported children for the first
time in 2021, their tax refund this year would be twice as large as last year’s.

Refunds may also be impacted if filers must return some or
all of the CTC advance payments. This could occur if a filer received an
advance payment based on 2020 tax information, but no longer qualified in 2021.

It is not clear how widespread the phenomenon of smaller refunds due to the CTC will be this year. In fact, the most recent IRS filing season data shows that the average taxpayer refund is up by about $400 per return from last year, as Politico reported. However, this data is hard to interpret because other provisions could impact refunds, such as taxpayers claiming economic impact payments at tax time.

Recent experience indicates that taxpayers receiving smaller refunds may not be happy about it. The first filing season after the passage of the Tax Cuts and Jobs Act (TCJA) produced a small uproar over smaller tax refunds. Although the TCJA reduced income tax liability for most taxpayers, changes to withholding ended up reducing some taxpayers’ refunds. As a result, some believed they faced a tax increase.

Despite the disappointment, the lower refunds do not necessarily reflect being worse off. On the contrary, taxpayers who qualify for the larger CTC in 2021 saw lower tax liabilities and higher after-tax incomes. Even more, the advance payments are better than receiving them all as a refund from the perspective of the taxpayer. Delaying the receipt of a tax benefit or over-withholding income tax is effectively an interest-free loan to the federal government.

The CTC’s advance payments may result in a few surprises at tax time, but taxpayers should focus more on their net tax liability not their refund.

The post How the ARPA child tax credit expansion can impact tax refunds appeared first on American Enterprise Institute – AEI.