By: W. Devin Wolf, CFP®
Modified for 2018 based on Tax Cuts and Jobs Act
If you have children qualifying for the Child Tax Credit and make in the neighborhood of $400,000 – $500,000 per year, this pertains to you. If not, feel free to ignore or share with someone who does.
What is the Child Tax Credit?
(Note: All numbers used below and in the examples pertain to the 2018 tax year; past and future tax years may be different than stated below.)
The Child Tax Credit is a $2,000 tax credit worth up to $2,000 for each child under the age of 17 (child has to be 16 years or younger at the end of the year). The credit amount is gradually phased out based on the following Modified Adjusted Gross Income (MAGI) levels:
- $200,000 for married couples filing separately
- $200,000 for single, head of household, and widow filers
- $400,000 for married couples filing jointly
Once you reach the phase-out income, the tax credit is reduced by $50 for each $1,000 of income above the threshold amount. The upper phase-out increases with the number of qualifying children you have and looks like this:
|Number of Kids||Phase Out Starts||Completely Phased Out|
Why does this matter for tax planning?
If you are in the 35% marginal bracket, for every extra dollar you phase yourself out of the tax credit, it costs you an extra 5% in taxes above your marginal rate (40% total).
Let’s say you are a young married resident, doctor, or professional with two kids currently in the Child Tax Credit phase out range (35% marginal bracket), but you know in the future you will likely be in the 37% marginal bracket or higher. Ignoring the Child Tax Credit, you may be inclined to contribute to a ROTH 401(k) or even complete ROTH conversions while you are in a lower tax bracket. However, you may be better off to wait on the ROTH conversions or take the immediate tax deduction of the Traditional 401(k) until you are completely phased out of the Child Tax Credit.
Here is an example of how one family could save $17,760 in taxes by utilizing $43,000 of Traditional 401(k) and HSA contributions to lower their MAGI from $443,000 to $400,000.
Married – 2 Children
|Without Deductions||With Deductions||Difference|
|Modified Adjusted Gross Income||$443,000||$400,000||$43,000|
|Child Tax Credit||$0.00||($4,000.00)||$4,000|
|Adjusted Tax Due||$97,459||$79,699||$17,760|
|Marginal Tax Rate||32.00%||32.00%||0%|
|Average Tax Rate Pre Credit||22.00%||18.89%||3.11%|
|Average Tax Rate Post Credit||22.00%||17.99%||4.01%|
|Tax Rate on last $43,000||41.3%|
If utilizing ROTH 401(k) contributions or ROTH conversions is appropriate for this family, they can do so at a lower tax rate once they have been completely phased out of the credit and are in the 32% marginal bracket.
Previously you had to keep an eye on the Alternative Minimum Tax (AMT) as the more dependents and tax credits you have the higher your risk was for being subject to AMT. With removal of exemptions and the alterations to the AMT tax, this is no longer as large a concern.