Determining what one owes in federal tax can seem mysterious. Total tax, standard deductions, itemizing, tax credits and deductions... what does it all mean? This blog will explain deductions and credits, including the new rules for the 2021 child tax credit.

Types of tax

Before we dig into tax deductions and credits it's important to note there are two tax systems in the federal tax structure: 1) income tax and 2) social security and medicare tax. Individual states that collect state income tax also have their own rules for state tax.

1. Federal income tax is a progressive tax, meaning the more you earn the more you will be taxed. Federal income tax rates range from 10% to 37%. Many mistakenly believe that it's bad to get thrown into the next tax bracket so better to not earn more money if you are close to the next tax bracket. Thankfully, the money earned first taxed at 10% will stay taxed at 10%, and only the new income will be taxed at the next highest rate. So do not worry about going into the next tax bracket.
2. Social security and medicare tax are typically 15.3%. Social security tax is 12.4%, but it only applies to income up to $142,800 (for 2021). After that social security tax stops. Medicare tax is 1.45%, and for those earning over $200,000 (for 2021) there is an additional Medicare tax of 0.9%. 

When someone is employed we refer to these two taxes as payroll tax. The employer pays half and gets to deduct that as a business deduction and the employee has the other half taken out of their paycheck.

For self-employed business owners, we refer to these two taxes as self-employment tax. The owner pays the full amount, but is allowed a deduction for 1/2 of the tax to make them similarly situated to an employer who can deduct their half. 

Deductions and credits

Deductions and credits both help to reduce the tax owed, but in different ways. There are two kinds of deductions (business and personal) and three types of credits (non-refundable, partially refundable and fully refundable). 

Business deductions

Businesses are permitted to take deductions for the costs they incur to operate the business. Revenue less these business deductions equals the net business income.

Business deductions are based on what was needed to operate the business. They are not subject to limitation the way personal tax deductions may be. Business deductions can even exceed revenue, creating a loss. Business deductions don't have any impact on personal deductions or tax credits. You still get personal deductions even when you take business deductions. 

Think of business net income as equal to the gross wages from a job. If a person is hired by an employer and the salary is $70,000, they will be paid $70,000 less the tax withholding. Similarly, if one owns a business and brings in $90,000 in revenue but incurs $20,000 of business expenses, they "earned" $70,000 as well. The business owner will pay tax on that $70,000 the same as the employee pays tax on their $70,000 of wages. 

Social security and medicare tax are based on either the wages paid to an employee or the net business income for a self-employed business owner. 

Personal deductions 

Personal deductions do not reduce social security and medicare tax, but they do reduce income tax. Personal deductions help to lower taxable income, which then results in lower income tax. Your total income is the income from all sources that may be taxed. From there, the government allows a number of deductions to reduce the taxable amount. As a result, the taxable income is usually significantly lower than the total you or your household earned for the year, thus lowering which tax bracket you fall into. 

Personal deductions include, among others:

• Standard or itemized deduction, whichever is higher. The standard deduction is a set amount for all taxpayers based on their filing status. For 2021, standard deductions are $12,550 (single), $18,800 (head of household) or $25,100 (married filing jointly). Itemized deduction means adding up personal medical expenses that are over 7.5% of adjusted gross income, property, state and local tax, mortgage interest, charitable contributions, and some other items. If the itemized amounts add up to more than the standard deduction, you take the itemized deductions.
• The Qualified Business Income (QBI) deduction.
• Self-employment health insurance premium deduction.
• Student loan interest deduction.
• SEP, 401k and traditional IRA retirement contributions.
• One half of self-employment tax deduction.
• Other deductions listed on the 1040 return or Schedule 1 of the 1040. 

Although these deductions help reduce income tax, a $1,000 deduction is not going to save $1,000 in tax. A $1,000 deduction will reduce income by $1,000 and if for example the tax rate was 20%, the deduction would save $200 in tax.

Tax credits

Tax credits do reduce dollar for dollar your tax liability. A $1,000 tax credit reduces the amount of tax you owe by $1,000. 

Some tax credits are non-refundable. This means they can reduce the tax to $0, but it can't go below $0. With this kind of credit, if you owed $600 in tax and you qualified for a $1,000 non-refundable tax credit, your tax would be reduced to $0. You would not get the full credit. 

Some credits are refundable tax credits. This means the government will give you money (in a refund) even if you don't owe any tax. So if you owed $600 and got a refundable tax credit of $1,000, you would then get $400 back as a tax refund. A credit can also be partially refundable, meaning you get a refund up to a certain point but may not get the entire credit in a refund.

2021 Child Tax Credit

The child tax credit is available to taxpayers who have a qualifying dependent child. For 2021, there are substantial changes to this tax credit making it confusing and something many taxpayers will want to pay more attention to this year. 

Note: This credit is based on your Modified Adjusted Gross Income (MAGI). MAGI is calculated by taking adjusted gross income (AGI) from your tax return and adding back certain income items. To calculate your MAGI, take the AGI and add back: a) deductions taken for IRA contribution, b) deductions taken for taxable Social Security payments, c) excluded foreign income, d) interest from EE savings bonds used to pay for higher education expenses, e) losses from a partnership, f) passive income or loss, g) rental losses and h) exclusion for adoption expenses.

Here is a summary of this credit comparing 2020 to 2021:

2020                                               
$2,000 per child under age 17
Partially refundable
Eligible for those with MAGI up to $200k

2021                                                                    
$3,000 per child under age 18
Plus an extra $600 per child under age 6
Fully refundable
Half of the credit can be paid in advance
Starts to phase out when MAGI exceeds $75k

This change is only in place for 2021. Although there is a proposal to extend it to 2025, it will revert back to 2020 amounts if it is not extended. 

If you would like to check your eligibility, this IRS tool can help: Advance Child Tax Credit Eligibility Assistant. 

Fewer taxpayers qualify

Fewer taxpayers will qualify for the child tax credit in 2021 because the income limits have been drastically reduced. This is important because if a taxpayer receives an advance payment that they later will not qualify to take on the tax return, the advance must be paid back. Do not assume you will get the child tax credit because you qualified for it last year. 

In 2020, a single or head of household tax filer could have MAGI of up to $200,000 and a married couple filing jointly could have a MAGI of $400,000 and still get the full child tax credit. For 2021, the credit starts to phase out, meaning it is reduced little by little, when taxpayers have the following MAGI:

• Single filers with MAGI over $75,000
• Head of household filers with MAGI over $112,500
• Married filing jointly filers with MAGI over $150,000

Due to this change, many people who received the child tax credit in the past will be surprised to learn that they do not qualify for this credit for 2021. 

Advance payments

The IRS will be sending out $250 payments for children under age 18 or $300 for children under age 6 starting July 15th and continuing through December 2021. This represents one half of the expected child tax credit divided by six months. The government is doing this to help families now, as we come out of the pandemic so they do not have to wait for their 2021 tax refunds to get the benefit. 

If you suspect the government does not have the information needed to send you an advanced child tax credit:

• Parents who have moved or whose bank information as changed can update their information on the Child Tax Credit Update Portal. 
• Parents who were not required to file taxes in 2020 can use the Child Tax Credit Non-Filer Signup Tool to get advance child tax credit payments. 

Opting out

The federal government is giving taxpayers the ability to opt out of the receiving the advance child tax credits.

To opt out, go to the Child Tax Credit Update Portal to unenroll from advanced payments. You will need create an ID.me account and be verified. Note: there are some reports that opting out using a mobile device works better than opting out on a desktop or laptop computer. 

Although the first round of payments are set to go out on July 15, 2021, you have the option to unenroll before each future disbursement date:

Payment date... opt out date
August 13... opt out by August 2nd
September 15... opt out by August 30th
October 15... opt out by October 4th
November 15... opt out by November 1st
December 15... opt out by November 29th

Here are reasons to consider opting out: 

• The tax credit has to be paid back if it turns out when you file taxes that you didn't qualify for the tax credit after all. It may be better to not get the advance credit than have to pay it all back in early 2022. 
• If you receive some of the credit in advance, that would mean getting a lower tax credit at tax time. If you usually get a refund, and now get an advance credit, you could potentially end up owing tax at year end. You may prefer to get all of it when you file 2021 taxes in early 2022.

There will be taxpayers who take the tax credit assuming that is money they can definitely keep, spend it, and wind up with a big tax bill. A large unexpected tax bill is not a good way to start off a new year.

There is a protection for lower earning taxpayers. Individuals earning less than $40,000 or couples filing jointly earning less than $60,000 will not have to repay any overpayment of the child tax credit. 

There will also be taxpayers who get the advance credits and still have plenty of credit left at year end that they don't owe tax. Only one half of the tax credit is being paid out during July-December 2021. It is not required to opt out, but the option exists for taxpayers who are concerned about receiving the advance payment. 

Alternatively, taxpayers may receive the advance credit and save it in a separate account just in case some or all does have to be paid back.

2022 Child Tax Credit

For 2022, the child tax credit reverts back to the previous 2020 tax credit levels, with no advance payments. There could still be legislation enacted for 2022 to change this, but none has been passed as of 3/4/2022, the date this blog was last updated. 

Estimated tax

When a self-employed business owner pays estimated tax, it is intended to cover the self-employment tax plus income tax that will eventually be due when the individual 1040 tax return is filed after year-end. To learn more about estimated tax, see the Estimated Taxes: When You Need to Pay blog or click the button below. 

Bottom line

Tax deductions reduce the amount of income that will be used to calculate your federal income tax, while tax credits reduce dollar for dollar the amount of tax owed. Some credits can be refunded, meaning that you can get a tax refund when a tax credit is greater than your tax liability. There are substantial changes to the child tax credit for 2021, and taxpayers may want to consider whether opting out of the advance payments will help protect them from owing tax at year end.