In 2017, Congress passed the Tax Cuts & Jobs Act (TCJA), which represents the largest tax reform since the 1980s. This reform is so wide-sweeping that it affects virtually everyone, usually in more ways than one. Given that, it’s pretty difficult for many people to figure out whether they’re better off or worse off than before.
While there are many aspects of TCJA that may impact each taxpayer, it’s important to understand each aspect in a little more detail, as opposed to trying to put it all together at one time. This article explores two aspects of TCJA as they relate to many parents: the elimination of personal exemptions & the increase in the child tax credit.
Elimination of Personal Exemptions
Prior to TCJA, Section 151 of the Internal Revenue Code allowed taxpayers a personal exemption for each member of their household. For tax purposes, a household means the taxpayer, spouse, and dependents that could not be claimed by another taxpayer. The IRS further prescribed tests to ensure that only one household claimed an eligible dependent. For example, in a divorced family, only one parent could claim a child as a personal exemption. Usually, divorce settlements would dictate the terms under which parents could claim children as personal exemptions.
Before the new tax law, in order to claim the personal exemption on behalf of a child, there were certain qualifying criteria. Namely, the child must:
- Be a blood or adopted relative
- Under age 19 at the end of the year (24 if enrolled in post-high school education) or permanently disabled
- Have lived with the taxpayer for over ½ the year
- Have not provided more than ½ of their own support
- Not file a joint tax return, except to claim a refund of income taxes paid
The original intent of the ‘personal exemption was to provide some minimum amount of tax-sheltered income that would allow for subsistence living. However, the annual increase in personal exemptions did not keep pace with inflation. As a result, the personal exemption amount ($4,050 in 2017), was barely ½ the poverty threshold.
Technically, TCJA has not completely eliminated personal exemptions. They are eliminated for tax years 2018 – 2025. This means that unless a future Congress votes to make TCJA changes permanent, we’ll see a reversion to the use of personal exemptions in 2026.
Child Tax Credit Increase
To counterbalance the elimination of personal exemptions, Congress incorporated several changes to the child tax credit. This represents the first significant change to the child tax credit since 2001. Unlike an exemption or deduction, which reduces taxable income, a tax credit is a direct reduction of the taxpayer’s tax bill.
First and most obvious, the child tax credit increased from $1,000 per year to $2,000 per year. Second, up to $1,400 of this tax credit is refundable. A refundable tax credit allows the credit to apply even if it goes beyond the taxpayer’s tax liability. In other words, a refundable tax credit can actually make a tax bill become negative, resulting in money going back to the taxpayer. In the case of the child tax credit, that refundable portion is up to $1,400 per child. Finally, the income phase-out threshold increased from $110,000 (for a married couple filing jointly) to $400,000. That means more families will be able to use the child tax credit than before.
The net result of the child tax credit increase is that more people will be able to use the child tax credit to lower their tax bills. Some people might even be able to reduce their tax bill below zero, resulting in money coming back to them.
What does this all mean?
Many people see this as a tradeoff. In fact, that was part of the point. Eliminating exemptions while increasing an existing tax credit made the tax code simpler. That was part of the intent. And it largely seems to be a wash. But is it?
- If you are in a lower tax bracket, you’re better off. Which would you rather have, a $4,050 reduction in your taxable income, or $1,000 in a lower tax bill? The correct answer is, “It depends on your marginal tax rate.” Your marginal tax rate is the tax rate at which your next dollar of income is taxed. For example, someone in the 10% tax bracket has a marginal tax rate 10%.
Let’s look at this problem from opposite sides of the picture. A 10% taxpayer with a $4,050 exemption would save $405 ($4,050 X 10%). That person would be better off getting the extra $1,000. However, a taxpayer in the highest tax bracket (now 37%), would save $1,498.50 with that exemption. That means the extra $1,000 child tax credit is not nearly as good as having that exemption in place. It turns out that the breakeven point is 24.6%. In other words, taxpayers in the 10, 12, 22, and 24% tax brackets are better off, while the 32, 35, and 37% taxpayers aren’t as well off.
- Higher tax bracket earners are still better off than they were last year. There is a counterpoint to the last statement: phaseouts. Two of them, in fact.
Personal exemption phaseout: When personal exemptions were allowed, there was an adjusted gross income (AGI) phaseout in place. That means households who exceeded $309,900 (for joint filers) experienced limited (or completely phased out) personal exemptions. So many of the high tax bracket earners never even got the full benefit of the personal exemptions in the first place.
Child tax credit phaseout: Additionally, for the child tax credit, the phaseout was much lower. Joint filers started seeing the phaseout at $110,000. After TCJA, that phaseout now begins at $400,000.
- This doesn’t necessarily mean that everyone is better off. For example, households with adult dependents are worse off because they lose the personal exemption, but don’t make up for it with an offsetting tax credit. This goes for a lot of families, whether they’re caring for aging parents or adult children with special needs. Also, this article doesn’t fully address all the other aspects of TCJA, namely the impact to itemized deductions, which would require another in depth article.
By eliminating personal exemptions, and increasing the child tax credit as an offset, TCJA does appear to make this part of the tax code a little simpler. But does it make it better for everyone? Without regard to the impact on the rest of their tax situation, most taxpayers will probably be no worse off by trading their personal exemptions for an increased child tax credit.