19 Sep Family and Education
Family and education tax breaks make raising kids less costly
This is the second post in Joel’s series 2016 / 2017 Tax Planning Guide: Year-Round Strategies to Make the Tax Laws Work For You.
Raising children and helping them pursue their educational goals — or pursuing your own — can be highly rewarding. But it also can be expensive. Fortunately, a variety of tax breaks can offset some of the costs.
Child and adoption credits
Tax credits reduce your tax bill dollar-for-dollar, so make sure you’re taking every credit you’re entitled to. For each child under age 17 at the end of the year, you may be able to claim a $1,000 child credit. If you adopt in 2016, you may qualify for an adoption credit — or for an income exclusion under an employer adoption assistance program. Both are up to $13,460 per eligible child. Warning: These credits phase out for higher-income taxpayers. (See Chart 1 below.)
Child care expenses
A couple of tax breaks can help you offset these child care costs:
Tax credit. For children under age 13 or other qualifying dependents, you may be eligible for a credit for a percentage of your dependent care expenses. Eligible expenses are limited to $3,000 for one dependent and $6,000 for two or more. Income-based limits reduce the credit percentage but don’t phase it out altogether. (See Chart 1.)
FSA. You can contribute up to $5,000 pretax to an employer-sponsored child and dependent care Flexible Spending Account. The plan pays or reimburses you for these expenses.
IRAs for teens
IRAs can be perfect for teenagers because they likely will have many years to let their accounts grow tax-deferred or tax-free. The 2016 contribution limit is the lesser of $5,500 or 100% of earned income. A teen’s traditional IRA contributions typically are deductible, but distributions will be taxed. Roth IRA contributions aren’t deductible, but qualified distributions will be tax-free. Choosing a Roth IRA is typically a no-brainer if a teen doesn’t earn income that exceeds the standard deduction ($6,300 for 2016 for single taxpayers), because he or she will likely gain no benefit from the ability to deduct a traditional IRA contribution. Even above that amount, the teen probably is taxed at a very low rate, so the Roth will typically still be the better answer.
If your children or grandchildren don’t want to invest their hard- earned money, consider giving them up to the amount they’re eligible to contribute. But keep the gift tax in mind. (Stay tuned for the Estate Planning post in this series, coming 11/21/2016.)
If they don’t have earned income and you own a business, consider hiring them. As the business owner, you can deduct their pay, and other tax benefits may apply. Warning: The children must be paid in line with what you’d pay nonfamily employees for the same work.
The “kiddie tax” applies to children under age 19 and to full-time students under age 24 (unless the students provide more than half of their own support from earned income). For children subject to the tax, any unearned income beyond $2,100 (for 2016) is taxed at their parents’ marginal rate, if higher, rather than their own typically low rate. Keep this in mind before transferring income-generating assets to them.
Are you eligible for these 2016 tax breaks?
1 Assumes one child. The phaseout end is higher for families with more than one eligible child.
2 The phaseout is based on AGI rather than MAGI. The credit doesn’t phase out altogether, but the minimum credit percentage of 20% applies to AGIs above $43,000.
If you’re saving for college, consider a Section 529 plan. You can choose a prepaid tuition program to secure current tuition rates or a tax-advantaged savings plan to fund college expenses:
- Although contributions aren’t deductible for federal purposes, any growth is tax-deferred. (Some states do offer breaks for contributing.)
- Distributions used to pay qualified expenses (such as tuition, mandatory fees, books, supplies, computer equipment, software, Internet service and, generally, room and board) are income-tax-free for federal purposes and typically for state purposes as well, thus making the tax deferral a permanent savings.
- The plans usually offer high contribution limits, and there are no income limits for contributing.
- There’s generally no beneficiary age limit for contributions or distributions.
- You can control the account, even after the child is of legal age.
- You can make tax-free rollovers to another qualifying family member.
- A special break for 529 plans allows you to front-load five years’ worth of annual gift tax exclusions and make up to a $70,000 contribution (or $140,000 if you split the gift with your spouse).
The biggest downsides may be that your investment options — and when you can change them — are limited.
Coverdell Education Savings Accounts are similar to 529 savings plans in that contributions aren’t deductible for federal purposes, but plan assets can grow tax-deferred and distributions used to pay qualified education expenses are income-tax-free. One of the biggest ESA advantages is that tax-free distributions aren’t limited to college expenses; they also can fund elementary and secondary school costs. ESAs are worth considering if you want to fund such expenses or would like to have direct control over how and where your contributions are invested.
But the $2,000 contribution limit is low, and it’s phased out based on income. (See Chart 1 above.) Amounts left in an ESA when the beneficiary turns age 30 generally must be distributed within 30 days, and any earnings may be subject to tax and a 10% penalty.
Education credits and deductions
If you have children in college now, are currently in school yourself or are paying off student loans, you may be eligible for a credit or deduction:
American Opportunity credit. The tax break covers 100% of the first $2,000 of tuition and related expenses and 25% of the next $2,000 of expenses. The maximum credit, per student, is $2,500 per year for the first four years of postsecondary education.
Lifetime Learning credit. If you’re paying postsecondary education expenses beyond the first four years, you may benefit from the Lifetime Learning credit (up to $2,000 per tax return).
Tuition and fees deduction. In some cases, deducting up to $4,000 of qualified higher education tuition and fees will save more tax than a credit. This deduction has been extended through 2016.
Student loan interest deduction. If you’re paying off student loans, you may be able to deduct the interest. The limit is $2,500 per tax return.
Warning: Income-based phaseouts apply to these breaks. (See Chart 1 above) If your income is too high for you to qualify, your child might be eligible. But if your dependent child claims the credit, you must forgo your dependency exemption for him or her (and the child can’t take the exemption).
Achieving a Better Life Experience (ABLE) accounts offer a tax- advantaged way to fund qualified disability expenses for a beneficiary who became blind or disabled before age 26. For federal purposes, tax treatment is similar to that of Section 529 college savings plans.
Case Study II
Tax-free savings for education add up
529 savings plans don’t offer a federal deduction for contributions, and the plans come with a lot of restrictions. Are their tax-deferred growth and tax-free distributions really worth it? They can be — especially if you start early:
When Sophie is born, her parents fund a 529 savings plan with a $5,000 contribution, and they put in another $5,000 on her birthday each year through age 17.
When Sophie turns age 18, her plan will be worth $163,800. And the $73,800 of growth in her plan will be completely taxfree, as long as all distributions are used to pay for qualified education expenses.
Total contributions made by parents
Balance at age 18
Note: This example is for illustrative purposes only and isn’t a guarantee of future results. The figures presume a 6% rate of return.