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Even though there have not been any significant changes to the federal income tax structure in 2021, average households may find their tax bill is higher this year than last year, resulting in taxpayers receiving smaller refunds or even owing money when filing their 2021 taxes.
Reasons why you might see a smaller tax refund this year:
The impact on cash flow of the advance child tax credit:
Average households (especially those with children) are likely to see a lower tax refund this year – or even owe federal income taxes due, at least in part, to changes in how the child tax credit was handled in 2021. Prior to 2021, families received the child tax credit amount as a lump sum in their tax refund – after they filed their taxes for the year. However, starting in the second half of 2021, many households received up to half of the child tax credit in a monthly prepayment (an advance of the year-end child tax credit). As a result, many families will not receive the entire credit as a lump sum; they will likely receive a smaller refund (or even have a “taxes due” amount) because part of the credit was paid in monthly installments in 2021.
For example, if a family is entitled to a $3,000 child tax credit and already received $1,500 in monthly prepayments during 2021, the family will only receive the balance of $1,500 when they file their tax return. This will likely be a surprise to most taxpayers. Relatedly, if a taxpayer usually receives a small income tax refund, when they file their 2021 tax return, they may find that they owe taxes instead.
Another wrinkle in this change in the distribution of the child tax credit is that for couples making more than $150,000 (or single filers making more than $75,000) some of the advance (prepaid) child tax credit they received in 2021 may actually need to be repaid to the IRS.
The pause in student loan repayments:
Even households without children may see an increase in their federal taxes due as a result of the pause in student loan payments. Taxpayers with student loans can typically deduct student loan interest paid on their federal taxes, so taxpayers who deducted student loan interest in prior years may find that they owe as much as $500 – $600 more in federal income taxes this year than in past years due to the suspension of student loan payments (including the tax deductible interest payments).
And taxpayers with mutual fund investments outside of their qualified retirement plans will likely find that the robust stock market in 2021 has created capital gains that will create additional taxes due, even if they did not receive any cash.
Reasons you might see a bigger tax refund this year:
On the other hand, there are some reasons why you might have a larger tax refund this year. Everyone with children should make sure to file a tax return this year – even if they have no income – as the child tax credit is fully refundable in 2021. So, families with eligible children can receive up to $3,000 or more per eligible child, even if they don’t otherwise owe any federal taxes (as was required in previous tax years). And eligible people who did not receive the third Economic Impact payment (made at the beginning of 2021), or who had children during 2021, can use their tax return to claim these amounts as well.
Also on the positive side, taxpayers who do not itemize can still take an additional deduction in 2021 for up to $300 of charitable contributions; for the average household, this could be another $50 -$75 in their pocket. This additional charitable deduction was first permitted in the 2020 tax year and still remains for the 2021 tax filing.
Your 2021 tax refund and Series I US Savings Bonds:
Unlike the Series EE Savings Bonds that many people are familiar with, Series I Savings Bonds have a variable interest rate which is based primarily on a semi-annual inflation rate. The interest rate for these bonds adjusts every six months based on the Consumer Price Index (CPI) offering investors an inflation-adjusted return currently at 7.12%. Individuals can purchase electronic bonds online through Treasury Direct in $25 increments up to $10,000 per year. However, most people do not realize that they can also purchase paper bonds in $50 increments, up to $5000, using their federal income tax refund.
Is this the right choice for your tax refund dollars? It depends. Like most savings bonds, the Series I Savings Bonds have some limitations: bonds must be held for at least one year, and if held for less than five years, a penalty equal to three months of interest will be assessed. On the plus side, interest income from these bonds is usually exempt from state income tax, and if the value of the bond is used for certain education expenses, the interest income may be excluded from federal income tax as well.
Looking Forward to 2022:
In addition to the effect of inflation on a family’s budget, as of today, the advance child tax credit and the enhanced child tax credit have expired. As a result, families with one or more children who were receiving monthly payments for these credits will have their monthly cash inflow decrease by potentially $150 – $300 per eligible child (depending on the family’s income and the child’s age). To be clear, the child tax credit still exists but in its previous form – paid in your tax refund at the end of the year, not via an advanced monthly payment.
There are many signs indicating that interest rates are likely to rise in 2022 (inflation, supply constraints, pandemic hiring issues, etc.). While rising interest rates can be beneficial to families that are using savings accounts, certificates of deposit, and money market accounts as savings vehicles, they are problematic for families with variable interest rate debt such as credit cards, home equity lines of credit, variable rate mortgages, etc. Required payments on these variable rate loans will increase as interest rates rise. What can you do? Make a plan to prioritize paying-off variable rate debts first. If you have a variable rate mortgage, you can price around banks/financial institutions to refinance your mortgage to a FIXED rate mortgage locking in these low rates. And, at the same time, if you have a variable home equity loan, refinance it into your new fixed rate mortgage.
If you are planning to buy a house in 2022, don’t panic! While interest rates will likely increase, they will not increase dramatically overnight; the specific house you choose and the price you pay for it will have more financial impact than a .25% change in your mortgage interest rate.