It is that time of the year: The days you wrestle with old receipts, canceled checks, W-2 forms, 1099s, and monthly statements from your banks, mortgage brokers, and credit card companies, documenting every possible payment to lower your federal income taxes.
According to the Internal Revenue Service (IRS), the average tax payer spends 16 hours preparing and submitting their tax returns, struggling with a complex tax code of almost four million words undergoing constant changes (579 times in 2010 alone). More than half of taxpayers rely on someone else to fill out the forms for them; another 30% use tax software from firms such as TurboTax to complete the tax forms. The IRS offers free tax help 24 hours a day, seven days a week, with tools to electronically file returns, calculate withholding, or determine whether a payer might be subject to the alternative minimum tax.
As a parent, tax season is also an opportunity to ensure that you recover as many tax dollars as possible to help cover the costs of raising a family. Most people neither want nor can afford to leave “money on the table” by failing to take advantage of the various deductions and credits to which they are legally entitled. Be sure you (and your tax advisor) identify and understand those sections of the IRS Code that relate to your family’s situation.
The Lifetime Financial Cost of Each Child
“If you sat down to tally up the total cost of having children, you’d never have them,” says Timothy Knotts, a father of four and a certified financial planner. Some expenses are apparent – food, clothing, childcare, medical bills, and education – while others are less so, including the possible loss of income when a parent stays home to birth or care for a child, as well as the additional living space and utilities associated with a bigger space. Health insurance premiums may go up, as well as transportation expenses from chauffeuring children to and from school, athletic events, and play dates.
According to the United States Department of Agriculture’s report “Expenditures on Children by Families, 2011,” the average annual cost of raising a child is about $15,000, excluding college costs. While the expenses vary considerably by household income level, annual expenditures increase each year as the child grows older. “The Wall Street Journal” estimated in 2007 that families in the top-third income bracket would spend $279,450 per child through age 17, a figure that has undoubtedly increased since this estimate. While there are a number of strategies a family can take to reduce expenses, the fact remains that the costs of raising a child often means delaying retirement savings.
After you’ve collected, sorted, and totaled your income and expense information, you or your tax advisor can begin to complete the tax forms to be submitted to the IRS. The information on the completed forms determines whether you will need to send a check for additional taxes, do nothing more, or get a refund of the taxes you’ve paid through withholding or quarterly payments during the past calendar year.
Pay particular attention to the following exemptions, deductions, and credits created specifically to minimize the taxes for which you may be liable:
1. Personal Exemption
Everyone is entitled to a personal exemption from income tax, and an exemption for anyone they claim as a dependent (spouse, children, aged parent). For 2015, the exemption per individual is $4,000. This means, for example, a family of four could earn $16,000 tax-free. Personal exemptions act just like deductions in that they reduce your taxable income so you wind up paying less taxes.
2. Standard or Itemized Deductions
The code provides a standard deduction for taxpayers who are married and filing a joint return of $12,600 for 2015. Different amounts apply to other filing statuses, such as single ($6,300) or head of household ($9,250). You have a choice whether to use the standard deduction or to itemize specific allowable deductions for such things as medical care, mortgage interest, taxes, and charitable contributions on your return. If the total for the itemized deductions exceeds your standard deduction, you should use the itemized deductions.
3. Medical Deductions for Children With Special Needs
Parents of children with special needs (autism, cerebral palsy, ADHD, or other diagnosed medical conditions) should consider itemizing deductions to cover such items as:
- Special schooling, training, or therapy, including exercise programs recommended by qualified medical personnel
- Aides required for the child to benefit from regular or special education
- Diagnostic evaluations
- Some home improvements
- Special medical diets
While such expenses are deductible only when they exceed 10% of adjusted gross income, once the threshold is reached, other eligible medical expenses are deductible.
4. Deductions for College Expenses
The following deductions are available even if you use the standard deduction rather than itemizing deductions on your return:
- Student Loan Interest Deduction. Generally, you can deduct up to $2,500 for interest which you were legally obligated to pay for a qualified student loan for yourself, your spouse, or your dependents. If your modified adjusted gross income (MAGI) is between $130,000 and $160,000 and you are married and filing jointly, the amount you can deduct is proportionately reduced. However, if your MAGI is above $160,000, no deduction is allowed.
- College Tuition and Fees Deduction. You may be able to deduct up to $4,000 for higher education tuition and fees paid for yourself, your spouse, or your children (even if you use the standard deduction) if:
- Your modified adjusted gross income is less than $160,000 if married and filing a joint return (or $80,000 if filing single or head of household).
- You do not use either the American Opportunity Credit, the Hope Scholarship Tax Credit, or the Lifetime Learning Credit.
5. Tax Credits for Children
The IRS code provides a number of refundable and nonrefundable credits that benefit parents directly over the years of a child’s dependency. (Refundable credits allow you to receive a refund in excess of the amount of tax you owe.) These credits are a direct offset (dollar for dollar) against any income taxes that may be due.
Any credit below not identified as refundable is a nonrefundable credit:
- Child Tax Credit. According to IRS Publication 972, each child under the age of 17 living more than half of the year with you (who you claim as a dependent on your return) entitles you to a credit of $1,000 with no limits on the number of children who qualify. If you have three children under the age of 17, expect to get $3,000 wiped off your tax bill. Like most credits, this one also has income restrictions, but they vary depending on how many children are claimed. The child tax credit starts to phase out at modified AGIs that exceed $110,000 for married couples filing together, $55,000 for married filing separately, and $75,000 for single parents. Further, a portion of the child tax credit is refundable depending on income and the number of children being claimed.
- Adoption Tax Credit. Parents receive a credit worth up to a maximum of $13,400 per child for tax year 2015. And if parents adopt a special-needs child, they can take the full credit, even if expenses totaled less than the value of the credit. In 2015, the credit starts to phase out when modified AGI exceeds $201,010.
- Child and Dependent Care Tax Credit for Children Under Age 13. Two-income households with children under 13 years of age qualify for a dependent-care credit to help cover childcare expenses. The IRS allows working parents and those looking for a job (students and disabled parents also qualify) a credit of 20% to 35% on expenses up to $3,000 in childcare for one child, and $6,000 for two or more children. This translates into a maximum credit of $1,050 for one child and $2,100 for two or more kids. The credit for parents earning more than $43,000 shrinks to just $600 for one child and $1,200 for two or more children.
- Earned Income Tax Credit. The IRS Code, detailed in IRS Publication 596, provides for a refundable credit for filers who meet a certain income threshold according to their filing status and the number of qualifying children they have. For example, married couples filing jointly with three qualifying children and 2012 earned income less than $53,267 are eligible to receive a credit. The more children you have, the more money you receive. Income and family size determine the amount of the credit, but the maximum credit in 2015 is $6,242.
- American Opportunity Credit. The refundable American Opportunity Tax Credit is for parents who are helping a child pay for college, and is worth up to $2,500 per student per year. To qualify, the student must be in his or her first four years of post-secondary education. (This credit can be used for no more than four years for each student, but there is no limit on the number of children who can qualify in any given year.) This credit phases out for married joint filers with modified AGIs greater $160,000 , and phases out above $80,000 for single parents. The credit is not available to taxpayers who elect to deduct college tuition or fees or the Lifetime Learning Credit for the same student.
- Lifetime Learning Credit. This credit covers those students who have piled up more than four years of college credit and any other family members taking classes. The credit is worth up to a 20% credit on tuition and other qualified expenses of $10,000 for a maximum credit of $2,000 per year, and is available for an unlimited number of years. For 2015, the Lifetime Learning credit is phased out for married joint filers with modified AGIs greater than $130,000, and is phased out for those filing as single, head of household, or qualifying widow(er) with incomes over $65,000.
Once your taxes have been filed for 2015, it is time to prepare for 2016 and later. The purpose of tax planning is to reduce the total amount of taxes to be paid by the thoughtful use of exemptions, deductions, and credits, as well as shifting income from a high-taxed category to a lower tax status by timing, source of income, or ownership of the income source.
All parents should consider the use of flexible savings accounts if they are available through employers. The use of pre-tax dollars, rather than after-tax dollars, to pay healthcare or childcare expenses is financially sound, with greater benefits as one’s gross income and potential tax liability increases.
Parents with special needs children should consider establishing a special needs trust to ensure the child will be properly cared for when the parents are no longer able to provide care. The trusts can be funded through annual gifts from parents and others and invested in a variety of assets, including life insurance, while being taxed at a lower tax rate than the donors’ normal rate. A qualified disability trust currently allows a $4,050 exemption if the trust’s modified AGI is less than or equal to $259,400.
For parents concerned about the cost of a future college education, there are a variety of different tax-advantaged plans available including:
- Educational IRA or Coverdell Education Savings Accounts. While contributions are not tax-deductible, the fund can grow tax-free if the proceeds are used to pay college costs or expenses for elementary and secondary school education. This includes private and parochial schools. Up to $2,000 can be contributed to a beneficiary’s account per year.
- State College Savings Plans. These qualified tuition plans, often called 529 plans after Section 529 of the tax code that authorizes them, allow parents to save money tax-free to pay future college expenses. There are two types generally available: the prepaid tuition plan, which locks in the the tuition price, but is generally limited to tuition and mandatory fees, and a college savings plan which can cover room, board, and books, as well as tuition. Although contributions are not deductible on federal returns, many states permit residents to deduct contributions on state returns.
- Revocable and Irrevocable Trusts for the Purpose of College Costs. While contributions are not deductible, transferring high-earning assets to a lower-taxed trust or the individual beneficiaries allows the principal to grow at a faster rate than might be the case when taxed at the higher tax bracket of the parents. An additional benefit is that the donors can establish the conditions under which the principal can be used. Since the beneficiary student will be paying taxes on the income as it is earned, he or she can continue to take advantage of the eligible deductions and credits for college during the college years.
While not as satisfying, navigating the U.S. tax code is almost as tedious and frustrating as raising a child from infancy to adulthood. Parents often rely on their own parents for wisdom during the more difficult times of child-rearing; a competent tax advisor can provide the same expert advice when it comes to minimizing your tax liability.
Do you feel you are using all of the deductions and credits to which you are entitled? Should the tax code be modified to increase deductions for children?