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Changes To The Latest COVID Relief Bill Create Massive Tax Rates for Some Families

When winter gives way to spring in the mountains, my garage pays the price. It’s the rare time of years when both bikes and skis are regularly in service, and that leads to one giant mass of boots and poles and pumps and wheels.

I’m sick of looking at it, but I’m also a lazy, lazy man. So if I offered you $10,000 to come on over and clean out my garage, would you do it?*

*offer not binding

Of course you would. But if the latest COVID relief bill should become law, you may want to pass on the job, because that $10K in income may cost you more than $10K in taxes. Wait…that can’t be right, can it?

Oh, it can, thanks to the confluence of a few legislative proposals that have made their way into President Biden’s stimulus package, which after passing the House of Representatives, is currently being discussed in the Senate. These well-intentioned provisions are designed to assist individuals and families in navigating the pandemic, but they interact in such a way that, in certain situations, they combine to create an unbelievably bad tax result.

The most notable piece of the proposed legislation is yet another round of stimulus payments to be made to individuals and their children, this time in the amount of $1,400 per eligible recipient. We discussed the details of the stimulus payment provision that previously passed the House here, but one big part of the plan has since changed. As you’ll note in the previous article, the stimulus payments would start to disappear for a married couple once adjusted gross income (AGI) – basically, the sum of all sources of income, less a few select deductions – exceeded $150,000. The payments would be phased out bit-by-bit, until they were completely eliminated once AGI for the couple reached $200,000.

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After the House passed the bill, however, a few Democratic Senators began to voice concern that the proposed payments would wind up in the hands of too many “high income” taxpayers. For President Biden, these concerns had to be taken seriously, because in order for the legislation to pass in the face of nonexistent Republican support, each and every one of the 50 Democratic Senators must vote for the bill. As a result, word began to circulate yesterday that the President had agreed to fully eliminate stimulus payments for a married couple once AGI reached $160,000, rather than the $200,000 limit found in the House bill.

The bill also endeavors to expand two existing incentives for families: the Child Tax Credit (CTC) and the Child & Dependent Care Tax Credit (CDCTC). As we discussed here, the CTC would be expanded from $2,000 to $3,000 ($3,600 in the case of children under 6), and the CDCTC — which provides a tax credit when parents pays childcare costs to allow the parents to work — would increase significantly from its current max of $2,100 to a new high of $8,000. All good news, right?

Yes, but like the stimulus payments, these expanded benefits start to disappear once a taxpayer’s AGI gets too high. For the CTC, just as it did with the stimulus payments, the new, expanded credit will phase out once AGI exceeds $150,000. And for the CDCTC, taxpayers will begin to lose the credit once AGI exceeds $125,000.

When you combine these three phase-outs, what you get is a likely-unintended but assuredly-bizarre result: taxpayers with large families who earn right around that $150,000 number can experience a marginal tax rate in excess of 100%.

Let’s prove it out. Here’s our case study:

H&W are married with three kids: A is 8, B is 5 and C is 2. B and C are in daycare, and H&W pay $16,000 per year for the program.

Scenario 1: H&W have Adjusted Gross Income (AGI) of $150,000

During 2021, H&W earned combined wages of $150,000. They have no other sources of income, and they claim the standard deduction of $25,100.

If we assume the latest round of COVID relief becomes law, including President Biden’s agreed-upon modification to the stimulus payment income level phase-out, here is what H&W’s tax picture will look like in 2021:

As you can see, H&W have completely wiped out their income with the three credits, leaving them with a refund of $1,145.

Scenario 2: H&W have Adjusted Gross Income (AGI) of $160,000

Assume the same facts as above, except in the waning days of 2021, W’s employer is so thrilled with her performance, she pays her a bonus of $10,000. H&W continue to claim the standard deduction of $25,100.

How big of an impact can an additional $10,000 of income make? Here is what H&W’s tax picture will look like now:

So if you’re scoring at home – and apparently you are, or you wouldn’t be concerned about the child tax credit – this amounts to a $10,520 INCREASE in tax resulting from only a $10,000 increase in income, or as we say in the tax world, a marginal tax rate of 105% on that income. Or to put it even more simply: YOU PAID MORE IN TAX THAN YOU EARNED.

How can this happen? The biggest culprit, obviously, is the fact that $7,000 of stimulus credits disappeared over a $10,000 span of income. That, in and of itself, is a 70% effective tax rate. Add in the phase out of the CTC (which begins at AGI of $150,000) and the CDCTC (which begins at AGI of $125,000), and you take an even bigger hit. Then, of course, there’s the regular 22% marginal rate on the $10,000 of income you earned. Put it all together, and you’re paying $10,520 of tax on $10,000 of income. And we didn’t even account for the additional payroll taxes on W’s $10,000 bonus.

Now, we can squabble all day over whether families earning $150,000 a year deserve enhanced credits and stimulus payments, and your position will likely depend on your income level and city of residence. There’s no consensus to be reached there.

What we can agree on, however, is that there’s something rather perverse about the notion of a family of five – regardless of income level – paying tax of $10,500 on income of $10,000. Fortunately, the bill is not yet final, and should members of the Senate read this (they will not), there’s still time to negotiate a fix.

In the meantime, I’ll be in the garage. I wouldn’t want to increase your tax bill by paying you to clean up my mess.

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