Last month, the first of six monthly child tax credit payments went out to more than 35 million households with about 60 million kids, according to the IRS. These payments will continue through the rest of 2021.
Without a plan in place for this extra money, it’s easy to spend a bit more than you normally would. But with extra planning, you can invest this extra money and make a difference in your child’s financial future.
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What Is the Child Tax Credit?
The Child Tax Credit is a credit available to parents with children under the age of 18. The credit provides financial support to families to help cover some of the costs that come with raising a child.
In general, families can claim a credit of $2,000 on their taxes, which means it either increases their refund by $2,000 or helps to reduce the amount they owe the IRS at tax time.
The credit is also refundable up to $1,400, meaning you can still receive money if the credit is more than your tax liability for the year.
2021 Changes to the Child Tax Credit
2021 brought major changes to the Child Tax Credit. As a part of the American Rescue Plan Act of 2021, increased the credit from $2,000 to $3,000 for children over the age of six, and from $2,000 to $3,600 for children under six.
Another major change to the credit is that instead of receiving the entire thing with your tax refund, you’ll receive half of it in the form of advanced monthly payments. These monthly payments started in mid-July and will continue through the rest of the year.
It’s important to note that the changes to the Child Tax Credit under the American Rescue Plan are temporary and apply only to the 2021 tax year. It’s possible that Congress will choose to make the change permanent, but that hasn’t happened yet.
There are income limits for receiving the enhanced Child Tax Credit. The full credit is available for all children ages 17 and under in families with 2020 or 2019 adjusted gross income of less than $75,000 for single parents and $150,000 for a married couple filing jointly, and ends for individuals earning $95,000 and married couples filing jointly making $170,000.
A Note on Opting Out
While parents will automatically receive the Child Tax Credit monthly payments, the IRS has given families a way to opt-out. Opting out of the payments might be a good idea in situations such as:
- Your income has increased, and you may not qualify for the entire tax credit
- You’re divorced and take turns claiming the Child Tax Credit
- Your child turns 18 in 2021, which would result in you having to pay back the credit
- You’d prefer to receive all of the money with your tax refund
How to Use Your Monthly Payments to Invest in Your Child’s Future
You can use the Child Tax Credit monthly payments to prepare for your child’s future. By investing the money, you can help your child pay for college, reach their future goals, and start their adult life without the financial stress that so many young people face today.
But before you consider investing, make sure your financial safety net is in place. Ask yourself whether it could be better used for one of these purposes.
- Covering a monthly budget shortfall: If your monthly income isn’t quite enough to make ends meet, then before investing your tax credit monthly payments, use them to cover monthly expenses.
- Paying off high-interest debt: Credit card debt and other high-interest debt can create a huge burden for families, and because of the high interest rates, it feels like you can never catch up. If your family is currently carrying debt with a high interest rate, pay that off before investing.
- Building your emergency fund: It’s not a matter of if emergency expenses will pop up — it’s a matter of when. It’s critical that you have an emergency fund in place to cover those unexpected costs or a potential job loss. If you don’t currently have an emergency fund in place, prioritize that over investing.
Why Invest Your Child Tax Credit Payments
If you don’t need your monthly tax credit payments to cover household expenses, pay off high-interest debt, or build your emergency fund, then opening an investment account for your child can help you maximize the benefits of these payments and set your child up to meet their future financial goals.
But why invest rather than save?
When you invest, you get to take advantage of what’s known as compound interest. In other words, your money earns money. And then the money you’ve earned also begins to earn money. Compound interest allows your money to grow exponentially.
Imagine that you invested $200 of that monthly tax credit payment in an investment account for your child. If you start investing that money from the time they’re born in an account with an 8% average annual return, then when your child turns 18, the account would be worth about $90,000, according to historical returns.
Yes, your child could potentially have $90,000 from investing just $200 per month. The account would be worth more than twice the amount you actually invested.
Imagine what that money could do for your child. It could fund their college education, help them buy their first home, or simply serve as a nest egg for their future.
You can track your investments — as well as your cash savings, loans and all other financial accounts — with free online tools like Personal Capital’s. Millions of U.S. households use this technology to budget, analyze their investments, and plan for long-term financial goals like college education and retirement.
Wondering where to start investing for your child? Here are a few accounts to consider.
529 College Savings Plan
A 529 college savings plan is a type of investment account designed to help families save for college. You can contribute to your child’s 529 plan and watch your investments grow.
Then, when your child heads off to college, they can withdraw the money tax-free to pay for qualified education expenses.
The downside to 529 plans is that if you use the money for anything other than qualified education expenses, you’ll pay taxes on the earnings, as well as a 10% penalty. Parents who aren’t sure their children will attend college might be hesitant to use this type of account.
A custodial account that an adult can open on behalf of their child. The earnings in this account aren’t tax-free like they are for the 529 plan, but the account provides more flexibility since your child can use the money for anything without penalty.
When you contribute to your child’s custodial account, you’re making an irrevocable gift. That means you can’t go back and withdraw the money later. Then, when your child reaches adulthood, they take control of the account.
There are two types of custodial accounts: UGMA accounts and UTMA accounts. The two are nearly identical, except the UTMA account can hold a greater variety of investments.
It might seem a little early to start saving for your child’s retirement, but you’d be surprised just how impactful investments in an IRA can be at a young age.
Remember how we talked about contributing $200 per month to an investment account for your child? Well, let’s say that from ages 14 to 18, you put that $200 per month into an IRA. After your child turns 18, the money simply grows in the account without any additional contributions.
By the time your child turns 60, the account would be worth more than $410,000, if we assume the same 8% returns. Nearly half a million dollars for your child’s retirement, and they didn’t add another dime.
And if they kept contributing that same $200 per month after they turned 18? They’d have about $1.5 million for retirement.
The one catch with an IRA is that you can only contribute as much as you earn, up to $6,000 per year. So for you to contribute that $200, your child must have a job where they earn at least $2,400 per year.
Health Savings Account (HSA)
A health savings account (HSA) might seem like an odd addition to this list of ways to invest for your child, but it’s true that HSAs are a type of investment account. And they come with more tax advantages than any other account on this list.
With an HSA, your contributions are tax-deductible, your money grows tax-free, and you can withdraw it tax-free as long as you spend it on qualified medical expenses.
If your child is young, there’s a good chance you’ve got years of medical bills. As your child grows up, those medical bills could include doctor visits, broken bones, braces and other dental care, eye care, and more.
HSAs are only available to families with high-deductible health plans, meaning they aren’t an option for everyone. And remember, the money can only be spent on qualified medical expenses, or you’ll pay a 20% penalty.
The Child Tax Credit has always provided financial support to parents, but the advanced payments created in 2021 are a unique opportunity to invest and contribute to your child’s financial future in a big way. The money you invest could pay for their education and help them avoid the student loans that burden so many young people today. It could help them travel the world, buy their first home, start a business, and more.
Each of the investment accounts we talked about comes with its own unique advantages, but they all each have downsides. If you aren’t sure which account is best for your child, consult a financial professional for guidance.
Personal Capital compensates Erin Gobler (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.