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Six Ways to Use Your Child Tax Credit Payments

What would you do with a couple hundred extra dollars each month?

Tens of millions of households are asking themselves that question this summer, thanks to a temporary tweak to the child tax credit included in the COVID-19 relief bill passed earlier this year. From July to December, the IRS will send eligible families monthly advances of up to $300 per child under the age of 6, and up to $250 per child ages 6 to 17, with the remainder available when people file their taxes.

The actual amount will depend on household income. Normally, parents of dependent children can claim a tax credit of $2,000 per child when they file their taxes, with phaseouts starting at $400,000 for married filers and $200,000 for single filers. This year, they’ll receive half that amount in advance. Congress also added a kicker for married filers earning less than $150,000 (or $75,000 for single filers) by expanding the tax credit to $3,600 per child under 6, and $3,000 per child ages 6 to 17. That extra credit phases out by $50 for every $1,000 in income above those amounts. As things stand now, the advance payments will end in December, but some in Congress hope to extend the program, or even make it permanent.

While these payments will be a lifeline to families still struggling to cover their day-to-day living expenses after the pandemic, many others may find themselves with extra money in hand each month. The challenge for them will be how to make the most of it. (If you don’t want to receive advance payments, you can opt out and wait until you file. More on that below.)

“It’s summer, things are opening again, and here’s a couple hundred extra dollars in your bank account each month. What could be more tempting?” asks Hayden Adams, director of tax and financial planning at the Schwab Center for Financial Research. “But consider this: That money could make a big difference to your family’s long-term finances. A little planning can help you avoid frittering it away.”

With that in mind, here are some tips for how you could put this money to work for your family.

Build an emergency fund

Are you prepared for a potential disaster or emergency? We suggest having enough cash on hand to cover three to six months’ worth of essential expenses, saved in an account you can access immediately. The idea here is that if things go south, you can avoid taking on debt from high-interest credit cards or drawing down your retirement funds. Having emergency cash on hand also helps you avoid selling long-term investments at inopportune times in the market.           

Consider funding a 529 savings account

Have you started saving for your child’s college years? A 529 plan is a state-sponsored program that allows parents, relatives, and friends to invest in a child’s (or any person’s) K-12 and college education. Earnings in a 529 plan grow federally tax-deferred, which means you don’t have to pay taxes on current investment income or capital gains, and you may even receive breaks on state taxes, as well, depending on which plan you choose. Even better, withdrawals are tax-free as long as you use the money to pay for qualified education expenses, which typically include tuition, books, school supplies, and room and board.         

“Every dollar saved is one your child won’t have to borrow,” says Hayden. “And some states even allow a tax deduction or a tax credit to boot.” 

Consider funding a health savings account

Are you using a health savings account (HSA) to save for your family’s medical bills? HSAs are tax-advantaged savings and investment accounts available to those with high-deductible health plans.1 Contributions to HSAs are tax-deductible.2 Capital gains, dividends, and interest accumulate tax-free.3 And you pay no tax on withdrawals for qualified medical expenses, such as doctor visits, prescription medications, eye exams, and dental care (see IRS Publication 502 for a complete list of qualified expenses).

If you use HSA funds for nonmedical expenses before age 65, you pay not only ordinary income tax but also a 20% penalty; however, if you use HSA funds for nonmedical expenses after age 65, you pay only ordinary income tax. In other words, you’d take no worse a tax hit than you would with an individual retirement account (IRA).

Consider funding an ABLE account

Do you have a child with special needs? So-called ABLE accounts are tax-advantaged savings accounts made available to people with disabilities. You can contribute up to $15,000 in post-tax dollars to a single ABLE account per year. Although contributions are not tax-deductible at the federal level, they may be at the state level. Any growth in such an account is exempt from federal taxes, so long as the money is used for qualified expenses, such as education, housing, and supplemental medical costs.

Consider funding a custodial account

Want to help your child save more for their future while investing less money? Investing early is a great way to tap the power of compound growth. One way to do this is through a custodial account—an investment account that you set up and manage on behalf of your child until he or she reaches adulthood (typically 18, 21, or 25 years depending on your state). At that point, the money automatically becomes his or hers.

You can make withdrawals at any time without penalty, as long as the money benefits the beneficiary (your child), and there are no lifetime limits on contributions.  Anyone (parents, grandparents, other relatives and friends) can make unlimited contributions to a custodial account once it’s open. However, a person can’t contribute more than $15,000 per year ($30,000 for a married couple) in 2021 without triggering the gift tax.

Income-tax wise, you’re exempt from taxes on the first $1,100 of earnings per year. The next $1,100 to $2,200 is taxed at the child’s rate (often 10 percent—the lowest income tax bracket). Anything over $2,200 is taxed at your income tax rate.

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Consider funding a Roth IRA for your child

Does your child have a summer job? If they have earned income this year, you can open a tax-advantaged custodial Roth IRA account on their behalf, and help them make what could be a down payment on an early retirement. As with a custodial account, contributions are made with after-tax dollars, but with a Roth IRA, contributions and earnings then grow tax-free—and you can withdraw them tax- and penalty-free after age 59½, assuming the account has been open for five years. You can contribute up to $6,000 in 2021, or the total of earned income for the year, whichever is less.

“You could offer to use the child tax credit funds to match any contributions your child makes, or even just put them in as a gift,” says Hayden. “Investing in a Roth IRA when you’re young and likely to have a very low tax rate means you can put more money to work for a much longer time.”

“Your child may laugh at the idea of saving for retirement during their teenage years,” he adds. “But imagine how happy they’ll be knowing they have a pot of tax-free withdrawals waiting for them when they’re older.” 

Use it as a stepping stone

The expanded child tax credit may not be around forever, and you shouldn’t count on Congress expanding it beyond this year. However, that doesn’t mean you can’t build on it in the future.

You could think of these payments as seed capital for a lifetime investing project. For example, if you have two children over the age of six, you could plan to invest your extra $500 a month while the program lasts, and then invest more modest sums on your own in the years ahead. Use this money to get started—and then make it a habit.

What if you don’t want cash payments?

The IRS has set up a portal where you can opt out of these payments if you think they aren’t for you—say, if they would disrupt your tax plans, or you have eligibility concerns.

For example, if your tax plans for 2021 already assume you’ll receive a regular tax credit when you file next year, you may not want to receive any money in advance, as that could mean a smaller refund or even having to pay the IRS.

Finally, as noted above, if your income increased this year and would render you ineligible for any child tax credit, you should consider opting out so you don’t end up having to pay it back at tax time.

1The IRS defines a high-deductible health plan as requiring annual out-of-pocket payments of $1,350 for an individual plan, and $2,700 for a family plan (see IRS Publication 969 for a complete list of requirements).

2While HSA contributions are exempt from federal income tax, they are not exempt from state taxes in Alabama, California, and New Jersey.

3State taxes may vary.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investors should consider, before investing, whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available in such state's qualified tuition program.

Investing involves risk, including loss of principal.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.

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