Phase Out

What Is a Phase Out?

A phase out refers to the gradual reduction of a tax credit that a taxpayer is eligible for as their income approaches the upper limit to qualify for that credit. Typically, there is a specific income range that the U.S. Internal Revenue Service (IRS) uses to determines what taxpayers may be eligible for a specific tax credit.

A taxpayer with an income at the lowest end of the range may be eligible for the maximum amount of the tax credit, whereas a taxpayer whose income falls on the highest end of the income range may be eligible for the minimum amount. There may be additional increments in between the upper and lower limits that are used to determine what amount of a specific tax credit a taxpayer may be eligible for (based on their reported income for the tax year). When a taxpayer's income exceeds the upper limit, they may become ineligible for the credit.

Understanding Phase Outs

Tax credits are provisions of the Internal Revenue Code (IRC) that are typically designed to benefit low- and middle-income households specifically. Since these tax credits are targeted toward taxpayers in a specific income bracket, above a certain income threshold, the amount of the tax credit is reduced. Preferential treatment in the tax code phases out for higher-income taxpayers; once a taxpayer surpasses a certain income level, the tax credit is no longer available to them.

The application of a phase out occurs with several different tax credits that are made available to taxpayers by the IRS. Some of these tax credits include the Child Tax Credit, the Retirement Contribution Savings Credit (Saver's Credit), and the American Opportunity Tax Credit.

Child Tax Credit

For the tax year 2020, the Child Tax Credit begins to phase out for married taxpayers filing jointly when their modified adjusted gross income (MAGI) reaches $400,000. If their MAGI falls below this number, they may claim the full amount of the tax credit. If it falls above this limit, the credit gradually reduces until their income reaches the income limit. For a married couple filing jointly, the Child Tax Credit disappears when their MAGI reaches $440,000. 

Note that as a result of the American Rescue Plan of 2021, signed into law by President Biden, the limit on the Child Tax Credit, previously $2,000, has been raised to $3,000 for children ages six through 17 and $3,600 for children under six. The credit is also now fully refundable; previously, only $1,400 was refundable. These changes are part of the American Relief Act of 2021 and are effective only for the 2021 tax year, unless extended by an additional act of Congress. This additional credit amount is phased out for singles with incomes above $75,000 and couples with incomes above $150,000.

Retirement Savings Contribution Credit (Saver's Credit)

A phase out also applies to the Retirement Savings Contributions Credit (also called the Saver's Credit). This credit was designed to help low- and middle-income Americans saving for retirement through qualified plans, such as 401(k) plans or Individual Retirement Accounts (IRAs). 

In the tax year 2021, for married taxpayers filing jointly to be eligible for the maximum tax credit, their AGI can be up to $39,500 ($39,000 for 2020). Above $39,500, the amount of the credit begins to phase out. For married taxpayers filing jointly, once their AGI is over $66,000 ($65,000 for 2020), they are not eligible for any amount of this tax credit. 

The American Opportunity Tax Credit

The American Opportunity Tax Credit (AOTC) is intended for taxpayers with qualified education expenses. For a taxpayer to claim the credit in the tax year 2020, they must have a modified AGI of $160,000 or less (if married filing jointly) in order to receive the full credit. If the taxpayer has modified AGI of more than $180,000 for married filing jointly, they can't claim the credit at all.

The American Opportunity Tax Credit phases out evenly over a $10,000 range, while some tax credits, such as the Child Tax Credit, decrease by $50 for every $1,000 or part of $1,000 in additional income above the phase out threshold.