Tax Treats for Parents
Like many relatives, Uncle Sam sometimes plays favorites, and at tax time, families with children receive special treatment. From long-standing credits, like the Child Tax and Dependent Care credits, to relatively new breaks, like the 529 college savings plans, the tax code is filled with ways to turn your little darlings into big savings.
"People with children, particularly those in the middle income bracket, may be able to benefit from the many tax savings programs available. With a little planning and careful attention to the rules, many parents can save money by not overpaying their taxes," says Cheryl Ellefson, a CPA tax manager at Olsen Thielen & Co. in St. Paul, Minnesota. "With a little planning and careful attention to the rules, many parents can shave hundreds, if not thousands of dollars, off their tax bills."
Tax breaks come in two varieties: credits and deductions. Credits are more beneficial because they reduce your tax bill dollar for dollar; deductions simply reduce your taxable income.
Here are some of the most valuable tax advantages available to parents:
Child Tax Credit
A qualifying child, claimed as your dependent, must be your son, daughter, adopted child, grandchild, or stepchild. To claim the full credit, your adjusted gross incomeyour income after adjustments for contributions to 401(k) plans, IRAs (individual retirement accounts), flexible spending accounts, and similar programsmust be less than $110,000 if you're a married taxpayer filing jointly or less than $75,000 if you're classified as a single head of household, or $55,000 if you're married filing separately.
Not-so-new Child Care Tax Credit
One caveat: You can't claim this credit if you or your spouse contributes to a dependent care flexible spending account (FSA) at workit's a one-or-the-other proposition. If you're lucky enough to have that choice, you'll likely find that the FSA (explained next) is almost always the better deal.
Also, qualifying Child Care Credit expenses are limited to the income you or your spouse earn from work, using the figure for whoever earns less. Under this limitation, if one of you has no earned income, you won't be entitled to any credit. Still, special rules essentially remove this limitation for a spouse who's a full-time student or disabled. The credit typically is computed as a percentage of your qualifying expensesin most cases 20%.
Flexible spending accounts
There are a few drawbacks to dependent care FSAs. First, you deposit money in an FSA on a "use it or lose it" basis. If you don't incur dependent care expenses that equal or exceed the amount in the FSA, you forfeit the surplus. In addition, once you elect to participate and elect the amount withheld, with limited exceptions, you may not change your election. Finally, it often takes several weeks to receive reimbursement for the expenses submitted.
Adoption Tax Credit
Beginning in 2002, you may qualify to take up to $10,000 of qualified adoption expenses as a credit against your income tax. Beginning in 2003, the income level below which you can claim the full exclusion increases to $150,000.
In addition, beginning in 2003, a credit of $10,000 for the adoption of a child with special needs is available in the year the adoption is final, even if the adoptive parents do not have $10,000 of qualifying adoption expenses. A $10,000 exclusion of income from gross wages under employer-provided adoption assistance also becomes available at that time, regardless of whether the adoptive parents of the special needs child have qualifying adoption expenses.
Deductible medical expenses
College Tax-Savings Plans
529 college savings plans
These plans, named after the section of the tax code that governs them, are the more attractive siblings of prepaid tuition programs. Anyone, regardless of income, can open an account and invest a hefty amount in stock and bond funds (more than $150,000 in many states). Most plans let you in with as little as $25 a month. You can use the money at any school in the country, and you maintain control until the child enters college.
Prior to legislative changes in 2001, 529 plans grew tax-deferred until withdrawn, at which point the earnings were taxed at the student's rate, making them only modestly better than saving in the child's name. Now, investment earnings inside the plans remain untaxed. But starting in 2002, distributions to students will be exempt from federal tax, too, as long as the money is used for higher education. (This tax exemption is set to expire in 2011.) This puts 529 plans clearly ahead of such options as saving in the child's name via a custodial account or in the parents' name in a fully taxable account.
Given the generous tax advantagesplus the opportunity to shelter enough cash to actually make a dent in those six-figure tuition bills529s are on their way to becoming the collegiate version of the 401(k). In addition, states increasingly are turning over the operation of their 529s to established money-management firms.
Unlike 401(k)s, these new programs may not be right for everyone. One major limitation is the lack of flexibility: Once you select an investment option, you cannot change itunless you follow a cumbersome rollover procedure. If you need to tap the account for any reason other than education, you will pay a 10% penalty. Another flaw: A 529 account can end up hurting your student's chances of obtaining financial aid.
To look at what your state may be offering, visit www.collegesavings.org, a Web site run by the College Savings Plans Network, an affiliate of the National Association of State Treasurers. It has some general information about the plans and links to states' sites. To get information over the phone, call 877-277-6496.
Education savings accounts
Coverdell Accounts are available to individuals with a modified adjusted gross income less than $160,000 for joint filers (that rises to $190,000 in 2002), or less than $110,000 if you're single. Although the account is in the child's name, the parent or guardian controls the account until all of its assets are withdrawn. No contributions may be made after the child turns 18, but the account can remain open until the beneficiary turns 30. If the funds haven't been used by that time, the account balance must be withdrawn within 30 days. In that event, applicable income taxes, plus a possible 10% tax penalty, would apply to earnings.
Withdrawals from a Coverdell Account are free from federal income taxes as long as they're used to cover the costs associated with education, such as tuition, books, fees, and supplies. Students enrolled half time or more also may make tax-free withdrawals to pay for room and board.
If the money is used for other purposes, earnings are taxed as ordinary income and may be subject to an additional 10% penalty. If the child named on the account doesn't attend college, you can transfer the account to another member of the family to pay for his or her higher education expenses.
Starting in 2002, you can use Coverdell Accounts to pay costs for elementary and secondary schools. Qualified expenses include tuition, uniforms, transportation, room, board, books, and computers and are allowable for students at public, private, and parochial schools. It would be tough to save a whole lot by the time a child entered first grade, but starting an account for an infant with the idea of using it for high school could be beneficial.
Hope Scholarship Credit
Lifetime Learning Credit
Unlike the Hope Credit, there is no limit on the number of years you can use it for tuition and expenses incurred. The Lifetime Credit is family-based, meaning there is only one credit per family no matter how many individuals are in college. The total allowed for the Lifetime Credit will increase to 20% of the first $10,000 after 2002.
If your income is too high to claim the Hope Credit or Lifetime Learning Credit and your child had substantial earned income, he or she may be able to take the credit instead. However, you will not be able to claim this child as an exemption.
Student loan interest deduction
"The deduction can be claimed regardless of whether you itemize your deductions," Ellefson says. "That's a big help to recent college grads who are paying off student loans and who usually don't have enough deductible expenses to itemize."
Keep in mind a few key restrictions: Parents can't deduct interest on a student loan taken out by their childeven if the parents are the ones paying off the loan. Only the person legally liable for the loan payments can claim the deduction. In a catch-22, the child who took out the student loan won't be eligible to deduct the interest, either, if he or she is claimed as a dependent on the parent's return. Children, however, can begin deducting interest payments on their student loans once they're no longer claimed as dependents.
Just the beginning
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