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You may have to repay some of the advance child tax credit next year. Here's what to know

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The advance payments of the enhanced child tax credit are set to start next month, but a big question on many parents' minds is whether they will end up owing on their taxes next year if they immediately spend the money. 

For some parents, the answer is probably yes, they will end up owing money next tax season. Others will likely be fine. But all eligible parents should review their finances before spending the payments, financial experts say. 

"This is not like the stimulus checks," said Nate Nieri, a California-based certified financial planner and founder of Modern Money Management. If you get overpaid in child tax credits or your financial situation changes this year so that you have a higher tax bill on your 2021 taxes, the IRS may demand you repay the credit come tax time.

"This is very important for planning and can easily become a trap for parents," he said.

How the new child tax credit payments are different

The child tax credit payments, which were set up and expanded under the American Rescue Plan passed earlier this year, amount to $3,000 annually per child ages 6 to 17 and $3,600 annually for children under 6. 

Eligible families will receive half of their credit in the form of monthly payments of up to $250 per school-age child and up to $300 per child under 6 from July through December 2021. The other half will be paid out when they file their 2021 taxes. The credit is income-based and starts to phase out for individuals earning more than $75,000 a year or $150,000 for those married filing jointly.

The IRS is set to send checks to 39 million eligible households on the following dates:

  • July 15
  • Aug. 13
  • Sept. 15
  • Oct. 15
  • Nov. 15
  • Dec. 15

It's important to understand that with these payments, the IRS is essentially prepaying a tax credit that you usually receive when you file your taxes, said Ben Wacek, a Minnesota-based CFP and founder of Guide Financial Planning.

"If you don't usually receive a refund, then the advance payments could actually cause you to owe more when you file your 2021 taxes," he said. 

For a 10-year-old child, the credit was worth $2,000 in 2020, which lowered a family's tax bill by that amount when they filed their return, Wacek explained. In 2021, the credit will be $3,000 for the same child, but half of it will be paid out in advance. 

When that same family files their taxes next spring, there will only be $1,500 left of the child tax credit to lower their tax bill. Everything else being equal, they will owe $500 more in 2021 than they did in 2020, Wacek explained.

"For this reason, if you usually owe when you file your taxes or cut it close, you might want to consider opting out of the advance payments or setting a portion of them aside to cover your tax bill in April," he said.

Who may need to be careful before spending

There are many families who could be affected by this. If you switched to a higher-paying job, for instance, or your spouse went back to work after being unemployed for most or all of 2020, you could be in a higher tax bracket next year, which could change your tax math, said Matthew Saneholtz, a Florida-based CFP with Tobias Financial Advisors.

Also, if you sold property for a gain and therefore earned more income in 2021, you could possibly have to pay the credit back when you file your 2021 tax return because you owe more taxes than the credit is worth, Saneholtz said.

If you fall into those categories or you can afford not to use the credit payments immediately, you may want to opt out, via an IRS portal that will be available soon, or at the very least, save half of each payment until you file your 2021 return. "I know [this is] not a fun answer, but nobody wants to be surprised by owing taxes," Saneholtz said.

Divorced parents should also be cautious, said Lili Vasileff, a Connecticut-based CFP and divorce expert with Wealth Protection Management. "This year marks a unique year for calculating child support and alimony because of the cash flow and tax credits available to [the] custodial parent," she said. 

It's likely that the IRS will begin sending the advance payments to the parent who claims the child on their tax return in 2020, because the agency typically defaults to using the most up-to-date information on file. 

"That can potentially raise issues for children who are moving between parents or households and share custody situations," Elaine Maag, a research associate in the Urban-Brookings Tax Policy Center, previously told CNBC Make It. That's especially true for parents who alternate years to claim the child tax credit, since one parent would be essentially getting the credit two years in a row. 

There is a safe harbor for individuals making less than $40,000, or $60,000 for couples filing jointly. If you make less than this and receive an overpayment of the child tax credit this year, you will not need to repay the amount. 

Of course, the safe harbor doesn't apply to everyone. An upper-income family with divorced parents, which is where splitting tax years is a more common arrangement, is less likely to be protected if they make a mistake.

What steps to consider taking

To avoid running into issues, start by taking a look at your 2020 tax return to see where your finances stand. You can also consider talking to a financial professional about your situation ahead of the first IRS payment on July 15.

The IRS is also set to release online portals in the coming weeks, including one that will help families determine whether they qualify for the payments. 

One of the portals will allow eligible parents to opt out of the advance payment program. Doing this will ensure that eligible families will receive the entire child tax credit next year upon completing their taxes. 

This week, the IRS rolled out the non-filer sign-up tool for those who didn't file taxes in 2019 or 2020 and who didn't previously register with the IRS for the pandemic stimulus payments. The tool allows parents and guardians to easily provide the IRS with information on themselves, their qualifying children or dependents and their bank to receive the payments.

Not sure how much you can expect in child tax credits? This calculator can help you estimate.

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