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Child Tax Credit

The child tax credit was enacted by Congress to lower the tax burden on lower income Americans with children. The child tax credit is equal to $1,000 for each qualifying child under the age of 17 by the end of 2011 or 2012, who is a US citizen, resident, national, or an adopted child who lived with you during the tax year. Except for the fact that the child must be younger than 17, all other tests for a qualifying child under the dependency exemptions must be satisfied. Starting in 2013, the amount of the child tax credit will be reduced to $500 per qualifying child. The child tax credit can only be claimed for a 12-month tax year.

The credit is figured on the Child Tax Credit Worksheet in Publication 972. However, the worksheet is not attached to the return. It is simply used to calculate the credit. Because it is a nonrefundable credit, it is limited to your ordinary income tax liability, which may be reduced by other credits which are claimed earlier on Form 1040, such as the foreign tax credit, credit for child and dependent care expenses, education tax credits, and the retirement savings contribution credit. A nonrefundable credit does not offset payroll tax liability — social security and Medicare taxes.

A phaseout of the credit starts when your modified adjusted gross income (MAGI), which is your adjusted gross income plus any foreign or American possession earned income exclusions plus any foreign housing deductions, exceeds the phaseout amount. The phaseout amount depends on filing status:

If your income is greater than the phaseout amount, then the credit is reduced by $50 for each $1,000, or fraction thereof, above the phaseout amount.

Example: Ava is a single parent with 2 dependent children and she earned $90,020 for the tax year. Because her income is $15,050 more than the phaseout amount of $75,000 for a head of household, she must reduce the $2,000 child tax credit that she would otherwise be entitled to by:

$90,020 – $75,000 = $15,020, which is rounded up to $16,000

$16,000/$1,000 = 16

16 x $50 = $800

Child tax credit = 2 x $1,000 – $800 = $1,200.

Note that although she only earned $20 more than $90,000, she must round her income up to $91,000, which is why the $50 is multiplied by 16 rather than 15.

Additional Child Tax Credit

Although the child tax credit is generally limited to ordinary income tax liability, an additional refundable credit may be claimed, for 2011 and 2012, on Form 8812, Additional Child Tax Credit if your earned income was greater than $3,000 or if you have more than 2 children, in which case, you can still claim a refundable credit even if your earned income is not over $3,000.

Because it is refundable, the additional child tax credit can be used to reduce payroll tax liability or AMT liability. The refundable credit is limited to the lesser of the unclaimed portion of the nonrefundable credit amount or 15% of your earned income above $3,000. Combat zone pay, which is otherwise excludable, can be included in earned income when calculating the additional child tax credit.

Example: Amy, who had earned income of $20,000, could only claim a $1,500 child tax credit for her 2 children, since that was the extent of her ordinary income tax liability. Therefore:

Amy can claim the lesser amount of $500 for the additional child tax credit.

For taxpayers with more than 2 children, an additional credit may be available by using the following generalized procedure:

  1. (Earned Income – $3,000) x .15
  2. Amount Taxpayer Paid in Social Security and Medicare Taxes as an Employee (listed in Boxes 4 and 6 of Form W-2) + 1/2 of any Self-Employment Taxes – Earned Income Credit
  3. Tentative Credit = Greater of #1 or #2
  4. Unclaimed Credit = Maximum Child Tax Credit – Claimed Portion of Credit
  5. Additional Child Tax Credit = Lesser of #3 or #4

Example: Rachel, who had earned income of $20,000, could only claim a $1,500 child tax credit for her 3 children, since that was the extent of her ordinary income tax liability. Rachel earned $15,000 as an employee, paying $1,148 in social security taxes — her employer paid an equal amount, but only her portion can be used in the following calculation. She also earned $5,000 net profit from a cleaning business, for which she paid $765 in self-employment taxes. Rachel also claimed an earned income credit of $5,049. Therefore:

  1. 15% of earned income over $3,000 = ($20,000 – $3,000) x .15 = $2,550
  2. $1,148 + 1/2 x $765 – $5,049 = $1,530.50 – $5,049 = -$3,518.50
  3. Tentative Credit = Greater of #1 or #2 = $2,550
  4. Unclaimed portion of the nonrefundable credit amount = $3,000 – $1,500 = $1,500
  5. Additional Child Tax Credit = Lesser of #3 or #4 = $1,500

With the additional child tax credit of $1,500, Rachel can claim the full amount of the $3,000 (3 children x $1,000) that she could have claimed, but for her limited liability for ordinary income tax.

Note that Steps 2, 3, and 5 ensure that the child tax credit, unlike the earned income credit, will never be greater than the taxpayer's total tax liability. So although it is a refundable tax, in that it reduces payroll tax liability, it is not a negative tax. And if the taxpayer is self-employed, then the child tax credit will never eliminate 1/2 of her self-employment taxes. (Though the earned income credit might.)

Also, Step 4 and Step 5, together, ensure that the following equation is always true:

Child Tax Credit + Additional Child Tax Credit ≤ Number of Children x $1,000

Tip: if you can claim the child tax credit or the additional child tax credit and you want to receive more take-home pay, then you should increase your withholding allowances by filing a new Form W-4 with your employer.

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