Kids are expensive.
We know. Many of our clients have young children. One of our partners, Landon, has three school-age children.
The fact that your kids will cost you a lot of money is no secret.
Your costs may be higher. You can use this calculator to get more specific.
Our experience shows that child care and education (especially if you do private school) are the largest expenses.
You Can Still Build Wealth
You can build wealth and have kids. Being a parent does not predestine you to destitution.
Thomas Stanley in his book The Millionaire Next Door found that the average millionaire is married with three kids.
Having kids helps us focus on the long-term. They can aid our ability to build wealth.
Luckily the IRS wants to help.
Understand the Tax Benefits of Having Kids
Having kids and buying a house are the two biggest things you can do to save money on taxes.
We will examine nine tax benefits offered to parents in this post. The tax benefits will be grouped by:
- Basic Benefits
- Help for Busy, Working Parents
- Reducing the Cost of Education
- Teaching Kids to Invest
We will examine the tax benefits associated with each area. The post will end with an analysis of how these benefits are phased out at higher income levels.
Even if your child is born on December 31, there are three basic benefits that you qualify for this year.
1. Dependent Deduction
A dependent exemption deduction of $4,050 is available for each dependent. A full deduction is allowed for any child born during the tax year.
$4,050 Per Child
This is huge and it adds up quick.
Let’s assume a 25% tax bracket. Each child will save you $1,013 in taxes.
$4,050 Per Child x 25% Tax Bracket = $1,013 Saved Per Child
You will receive this benefit every year until your child turns 19. The benefit continues to age 24 as long as your child remains a full time student.
2. Child Tax Credit
You may receive a child tax credit of $1000 per child for children under the age of 17.
Unlike the personal exemption, which is a deduction, this is a tax credit. A deduction reduces the amount of income you pay taxes on. The amount you save with a deduction is based on your tax bracket, which is based on your income. The more you make the more you save.
A credit is a $1 for $1 reduction in the amount of tax you owe. It is not based on your income.
$1,000 x Number of Children = Amount of Taxes Saved
Like the personal exemption, the child must be claimed as your dependent to qualify.
3. Head of Household Filing Status
This benefit is for single parents. Individuals who qualify to file as head of household receive a higher standard deduction and lower tax rates.
As a single tax payer your standard deduction is $6,300. Qualifying as head of household with children, your standard deduction increases to $9,250.
$2,950 paid at a lower tax rate
Your tax rate also drops.
Going back to the 25% tax bracket we used in our personal exemption example. Single tax payers enter the 25% tax bracket at income levels of $37,651 to $91,150.
Filing as Head of Household with kids, you avoid the 25% tax bracket until your income reaches $50,401.
$12,750 in income at a lower tax bracket
Plus, you avoid creeping up to the next tax bracket until your income reaches $130,150.
A $39,000 difference filing as Head of Household
To qualify, you must be unmarried on the last day of the tax year and have maintained a household where the child lived for more than one half of the year.
Start Saving from Birth
The basic benefits of having a child accrue to you as soon as the child is born. Even if your child is born on December 31, you will start saving on your taxes this year by:
- Increasing your personal exemptions
- Qualifying for the child tax credit
- Changing your filing status (single parents)
The tax savings start immediately.
Eventually, you have to go back to work. Your career marches on. The tax savings continue as you go back to work.
Tax Benefits to Help Busy, Working Parents
It’s Monday morning. The alarm goes off. You lie in bed, your mind screams “No!”, but your bank account screams “Yes!”
Someone has to pay for these kids. That someone is you. Welcome back to work.
There are two tax benefits to help busy, working parents.
1. Dependent Care Credit
You may take a dependent care credit for daycare expenses incurred in order to work. Being a credit and not a deduction, this is a dollar-for-dollar reduction in taxes owed.
The amount of the credit is a percentage of the total you spend on child care. The total expenses you can claim to determine the credit is limited based on your number of children:
- $3,000 Total – One Child
- $6,000 Total – Two or More Children
Earning over $43,000, you get to claim as a credit 20% of your total expenses up to the limits above. This means the amount of the credit is generally limited to $600 for one child and $1200 for 2 or more children.
Note – If you are filing a joint return, both parents must work.
2. Flexible Spending Account (FSA)
Your employer may offer an FSA or cafeteria plan that includes a pre-tax withholding for dependent care. The maximum is set by your employer but can not exceed $5000 per year per family.
Be careful not to exceed $5000 if each parent has access to an FSA plan.
If you participate in a dependent care FSA, you do not also get the full dependent care credit.
Which Do I Choose? The dependent care FSA or the dependent care credit?
The dependent care FSA is your best choice.
- Two kids
- $5,000 total expenses
- 25% tax bracket
With the dependent care credit your tax savings are:
$5,000 x 20% credit amount = $1,000 saved
With the dependent care FSA your tax savings are:
$5,000 x 25% tax bracket = $1,250
You save $250 more by using the dependent care FSA.
Watch Out for Phantom Child Care Expenses
Lurking in the depths of your credit card statement, there may be phantom child care expenses. These expenses at first glance do not seem to qualify.
But, closer examination reveals an expense that can be deducted or paid from the FSA.
A great example are private schools.
Private school tuition is not deductible. After school care provided by your private school is.
Some private schools charge one flat amount for the total. They do not itemize the difference between tuition and after school care.
Dig into the details. Determine what portion of the total is for after school care and deduct it.
Busy, Working Parents – That’s Right You – Need Help
You have taken advantage of the basic benefits. You know that a dependent care FSA is the best way to pay your child care expenses.
Now that you are back to work, let’s get even more help by using the tax benefits of saving for your child’s education.
Education Tax Benefits
Kids are expensive. College is expensive. It’s all expensive.
- Average private school tuition is $10,003 per year
- A “moderate” college budget for in-state public college is $24,610 per year
All total, you could spend $130,039 on private school and $98,440 on college.
Plus, that’s just today’s cost. Inflation will make the total cost much higher.
You need to take advantage of every tax benefit you can find. Here are four to consider.
1. Coverdell Education Savings Accounts (ESA)
Up to $2000 per child can be contributed to a Coverdell account per year. You do not get a deduction but all investment income or capital gain earned in the Coverdell account is tax free if used to pay for tuition or other qualified education expenses.
Unlike the section 529 plan, the Coverdell accounts can be used to pay for private elementary, middle school, or high school expenses.
NOTE – The Limit is $2,000 per child, per year.
You cannot contribute $2,000 and then have the grandparents contribute $2,000. The limit is $2,000 total.
Also, the number of investment companies offering ESA accounts is very limited. Big custodians like Fidelity and Vanguard no longer offer ESA accounts. Here is a list of current providers.
2. Section 529 Plans
Parents and grand parents often contribute to a Section 529 Plan. Amounts contributed are not deductible but the income or gains in the account grow tax free as long as the withdrawals from the Plan are used for college education.
NOTE – Be sure to check your state income tax rules. You may qualify for a state income tax deduction by contributing to your state’s 529 plan.
Special gift tax rules allow a parent or grand parent to contribute up to $70,000 in one year per person.
If you start funding when the child is young, you can accumulate a significant amount of tax free growth.
3. Education Tax Credits
Tax credits are available for parents who pay for post secondary tuition for a dependent child. This includes college or vocational education.
The maximum American Opportunity Tax credit is $2500 per year per student. The maximum Lifetime Learning Credit is $2000 per year per return.
4. Paying Tuition Direct
This is a lesser known benefit that can be a great way for grandparents to help pay for your child’s education.
Most gifts over $14,000 require the giver to file a gift tax return and use up part of their lifetime estate and gift tax exemption. Married tax payer can combine their gift tax exclusion to give $28,000.
There are two exceptions to this rule:
- Payment of medical expenses
- Payment of tuition
Grandparents of other relatives can gift unlimited amounts in the form of tuition payments. The payments must be made directly to the college or university. They cannot be first received by you or your child.
This can be a great way for family members to assist in your child’s education and reduce the amount of their taxable estate.
Going Beyond the Basics, Child Care, and Education
By now, you have the basics covered. You know how having a child reduces your taxes from the moment of birth. You know that your dependent care FSA is the best way to pay for child care. You have a plan for saving taxes while paying for college.
Now, let’s set your child up for success. Teaching them how to build wealth starts now.
Tax Efficient Ways to Teach Kids How to Invest
Start early teaching your kids how to save and invest. Here are two tax advantaged ways to get started now.
1. Gifting Stock to Your Kids
By gifting stock to your kids, some investment income or capital gains can be reported on the child’s tax return at lower tax rates.
But, there is a limit of $2100 in investment income that can be taxed at the child’s rate before the “Kiddie tax” applies. Any amount above $2100 per year is taxed at the parent’s rate.
You can also do this with shares of mutual funds purchased in taxable accounts.
2. Custodial Roth IRA
It may be babysitting or mowing lawns. Eventually, your child starts to earn an income.
Don’t let this opportunity go to waste. Have your child fund a Roth IRA.
The child can contribute up to the lesser of $5,500 or their earned income. Contributions grow tax free forever.
Gifting stock and opening a Roth IRA are two ways to get your kids started early on their way to wealth.
High Income Earners – Know When the Benefits Stop
Many of the tax benefits associated with kids stop or are phased out at certain income levels.
Four of the benefits we have looked at here are subject to phase out.
- Personal Exemption
- Child Tax Credit
- Coverdell ESA
- Education Tax Credits
We will examine the limits on each.
Personal Exemption Phaseout (PEP)
For 2016, the phaseout begins at the following income levels:
- Head of Household – $285,350
- Married Filing Jointly – $311,300
You lose 2% of your personal exemptions for each $2,500 or part of $2,500 that your income exceeds the levels above. Your adjusted gross income is reported on line 37 at the bottom of form 1040.
Personal exemptions are reduced to $0 at the following amounts:
- Head of Household – $407,850
- Married Filing Jointly – $433,800
Watch Out for Large Income Years
Your salary and bonus may not exceed the amounts above. But, a big acquisition or stock option event could put you past the limit.
This can compound the effect of higher income at higher tax brackets by limiting one of the basic benefits.
The Real Impact of PEP
As Michael Kitces wrote, PEP may be labeled as a limit on deductions, but in reality it functions as a surtax.
The impact to those who exceed the income limits is a 1% rate increase per family member.
In most cases, this cannot be avoided, but it should be planned for in advance.
Child Tax Credit Limitation
This credit is not available to higher income taxpayers. It starts to phase out if your modified adjusted gross income exceeds $75,000 (head of household) or $110,000 (joint).
The determination for this phase out differs from the personal exemption phase out (PEP). PEP is based on your adjusted gross income found on line 37 of form 1040.
The child tax credit phase out is based on modified adjusted gross income.
Modified adjusted gross income is your adjusted gross income plus any deductions for:
- Student loan interest
- One half of self employment tax
- Tuition and fees deduction
- Ira contributions
- And others…
Coverdell ESA Eligibility
You are not eligible to contribute to a Coverdell account if your modified adjusted gross income exceeds $220,000 (joint) or $110,000 (single). The contribution begins to phase out at $190,000 (joint) and $95,000 (single).
But, there is a way to avoid these income limitations by gifting the $2000 to your child. The child then establishes the Coverdell account with the parent as guardian.
We advise you to check with your Tax Advisors if you are in this situation.
Education Tax Credits – American Opportunity and Lifetime Learning
Higher income taxpayers may not be eligible for these credits since they are subject to phase out.
American Opportunity Credit
The American Opportunity Credit starts to phase out at $80,000 (single) or $160,000 (married filing jointly). It is completely eliminated at $90,000 (single) or $180,000 (joint).
Lifetime Learning Credit
The phase out starts at $55,000 (single) or $111,000 (joint). The credit is completely eliminated at $65,000 (single) or $131,000 (joint).
Plan in Advance
Know the benefits and their limits. Plan in advance to avoid losing benefits. Manage high income years. Time expenses during low income years to take advantage of otherwise eliminated benefits.
Maximize the Tax Impact of Your Kids
Use these nine tax benefits to maximize the impact your kids have on your tax return. The impact over a lifetime can be huge.
The child tax credit alone can result in $17,000 in total tax savings ($1,000 per year over 17 years) per child.
Start planning now to save more as you have kids. Working with an advisor helps. You can get started by scheduling your call today.