Financial Resource Center


Tax Treats for Parents

by Maura Keller / January 14th, 2002

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
The Child Tax Credit is a dollar-for-dollar reduction in your taxes. For 2001, Uncle Sam grants a $600 tax credit for each child younger than age 17 at the end of 2001. Through 2004, the tax credit stays at $600. In 2005 through 2008, the credit jumps to $700. In 2009, it becomes $800 and it hits $1,000 by 2010.

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 income—your income after adjustments for contributions to 401(k) plans, IRAs (individual retirement accounts), flexible spending accounts, and similar programs—must 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
Many of the best ways for parents to save on taxes include long-standing but often overlooked provisions. Chief among them is the Child Care Tax Credit, which gives working parents a credit for 20% to 30% of their child-care expenses, up to $2,400 for one child and $4,800 for two or more. To claim the credit, your child must be younger than age 13, and your caregiver must be paid on the books: You'll have to provide a Social Security number or taxpayer ID for your caregiver. You also must include on the return the Social Security number of the children receiving the care. There's no credit without it.

Coverdell Education Savings Accounts offer the potential for tax-free investment growth.
Among the expenses you can claim: daycare, nursery school, private kindergarten, summer day camp, or a licensed toddler program, as well as before- and after-school programs. Just about any child care program that allows you and your spouse to go to school or work makes the cut. The cost of household services also can qualify as long as the cost goes at least in part toward the care of the individual.

One caveat: You can't claim this credit if you or your spouse contributes to a dependent care flexible spending account (FSA) at work—it'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 expenses—in most cases 20%.


Flexible spending accounts
If your employer offers a dependent care flexible spending account, you may wish to consider participation in the FSA instead of taking the Child Care Tax credit. Remember, you can't use both. Under a dependent care FSA, you may contribute up to $5,000 on a pretax basis. Your employer withholds the contribution from your paycheck and places it with a plan administrator in a noninterest bearing account. As you incur dependent costs, you submit a statement with the administrator substantiating the cost and receive reimbursement.

Tax breaks come in two varieties: credits and deductions.
Dependent care FSAs generally are more advantageous than taking the tax credit if you are in the higher tax brackets. In addition to federal income tax savings, participating in a dependent care FSA will result in savings on Social Security taxes because the amount you contribute to the FSA isn't included in wages for Social Security purposes.

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
Parents who adopted in 2001 can claim a credit for up to $5,000 of the expenses they incur during the adoption process ($6,000 for a special-needs child) in the year that the adoption becomes final. Qualifying expenses include agency fees, attorney fees, court costs, and necessary travel expenses.

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
Congress makes it tough for most people to write off medical expenses. To qualify, the total amount you spend on health care in the year for which you're claiming the deduction must exceed 7.5% of your adjusted gross income. If your family earns $60,000 a year, you'd have to have shelled out more than $4,500 in nonreimbursed expenses before you could deduct a dime.

You can't claim the Child Tax Credit if you or your spouse contribute to a dependent care FSA.
But many new and prospective parents may have racked up such sizable medical bills, particularly if they used costly procedures and services not covered by managed care. Some new-parent expenses you can deduct from your income taxes: in vitro fertilization, childbirth classes, transportation to and from the doctor and hospital for checkups and treatment, pre- and postnatal vitamins, genetic testing, and the cost of a doctor-recommended baby nurse. Since the name of the game with the IRS (Internal Revenue Service) is substantiation, be prepared to back up the deduction with a note from your doctor.


College Tax-Savings Plans
The greatest financial worry of most American families used to be "Will I have enough to live on after retirement?" Some polls, however, now indicate that this has changed. The new greatest area of financial concern is "How will I be able to afford a college education for my children?"


529 college savings plans
Families interested in saving to finance a child's college education get a number of tax benefits under the recently enacted tax-cut law, with the focus on the tax exemption bestowed on Section 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 advantages—plus the opportunity to shelter enough cash to actually make a dent in those six-figure tuition bills—529s 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 it—unless 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
Education IRAs, now called Coverdell Education Savings Accounts, offer the potential for tax-free investment growth when you use the account to pay for a child's qualified higher education expenses. You may invest up to $500 per child per year in a Coverdell Account; however, this will increase to $2,000 in 2002. Note: This does not count against the maximum you can invest in your own traditional or Roth IRA.

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
The tax breaks that got a big buzz when introduced in 1998 were the Hope Scholarship and Lifetime Learning credits. With the Hope, for your first $1,000 in out-of-pocket tuition and fees (not room and board) you get a 100% tax credit, and 50% on the next $1,000, or a total $1,500 credit. Keep in mind that you only can use this credit in the first two years of college. You can take a Hope credit for each eligible child.


Lifetime Learning Credit
The Lifetime Learning Credit of 20% of up to $5,000 of qualified tuition expenses applies to undergraduate, graduate, and professional coursework as well as to students acquiring or improving job skills. Both credits phase out completely if your income is more than $100,000 (married) or $50,000 (single or head of household).

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
Beginning Jan. 1, 1998, taxpayers who had taken loans to pay the cost of attending an eligible educational institution for themselves, their spouse, or their dependents were eligible to deduct interest they paid on these student loans. Today, the maximum deduction each taxpayer is permitted to take is $2,500 in 2001 and thereafter.

Children can deduct student loan interest payments once they're no longer claimed as dependents.
Up until 2001, the deduction was available only for interest payments made during the first 60 months in which interest payments are required on the loan. But as a result of the Tax Relief Act of 2001, the 60-month limit is eliminated effective Jan.1, 2002, a great help to college grads who take many years to pay off college debts. In addition, beginning in 2002, the new law increases the income phase-out ranges to $50,000 to $65,000 for single taxpayers and to $100,000 to $130,000 on joint returns.

"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 child—even 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
Once you've filed your return and put your tax-saving strategies into place, don't think your work is done. "You don't want to make all of your financial decisions based on taxes," Ellefson says. "Since you already have all the paperwork handy, review your whole financial picture to make sure you're making the most of your money."

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