Tax-planning opportunities abound for parents, students — even grandparents
If you’re a parent, a student or even a grandparent, valuable deductions, credits and tax-advantaged savings opportunities may be available to you or to your family members. Some child- and education-related breaks had been scheduled to become less beneficial beginning in 2013, but the American Taxpayer Relief Act of 2012 (ATRA) extended most enhancements — in many cases, making them permanent.
Tax credits reduce your tax bill dollar-for-dollar. (See the Chart “Tax deductions vs. credits: What’s the difference?”) So make sure you’re taking every credit you’re entitled to. ATRA made the benefits of the following credits permanent:
- For each child under age 17 at the end of the year, you may be able to claim a $1,000 credit. Warning: The credit phases out for higher-income taxpayers.
- For children under age 13 (or other qualifying dependents), you may be eligible for a credit for a portion of your dependent care expenses. Eligible expenses are limited to $3,000 for one dependent, $6,000 for two or more. Income-based limits reduce the credit but don’t phase it out altogether. The credit’s value had been scheduled to drop beginning in 2013, but ATRA made higher limits permanent.
- If you adopt, you may be able to take a credit or use an employer adoption assistance program income exclusion; both are limited to $12,970 for 2013 and $13,190 for 2014. An income-based phaseout also applies.
For more information on the income-based phaseouts that apply to these credits, see the Charts “2013 family and education tax breaks: Are you eligible?” and “2014 family and education tax breaks: Are you eligible?”
Dependent care FSA
You can redirect up to $5,000 of pretax income to an employer-sponsored child and dependent care Flexible Spending Account. The plan then pays or reimburses you for child and dependent care expenses. You can’t claim a tax credit for expenses reimbursed through an FSA.
Employing your children
If you own a business, consider hiring your children. As the business owner, you can deduct their pay, and other tax benefits may apply. They can earn as much as the standard deduction for singles ($6,100 for 2013; $6,200 for 2014) and pay zero federal income tax. They can earn an additional $5,500 annually in 2013 and 2014 without paying current tax if they contribute it to a traditional IRA. Warning: They must perform actual work and be paid in line with what you’d pay nonfamily employees for the same work.
Roth IRAs for teens
Roth IRAs can be perfect for teenagers because they likely have many years to let their accounts grow tax-free.
The 2013 and 2014 annual contribution limits are the lesser of $5,500 or 100% of earned income, reduced by any traditional IRA contributions. Contributions aren’t deductible, but if the child earns no more than the standard deduction for singles ($6,100 for 2013; $6,200 for 2014) and has no unearned income, he or she will pay zero federal income tax anyway. If a child’s earned income exceeds the standard deduction, the income likely will be taxed at only 10% or 15%. So the tax-free treatment of future qualified distributions will probably be well worth the loss of any current deduction.
If your children or grandchildren don’t want to invest their hard-earned money, consider giving them the amount they’re eligible to contribute — but keep the gift tax in mind.
The “kiddie tax”
The income shifting that once — when the “kiddie tax” applied only to those under age 14 — provided families with significant tax savings now offers much more limited benefits. Today, the kiddie tax applies to children under age 19, as well as 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 kiddie tax, any unearned income beyond $2,000 (for 2013 and 2014) is taxed at their parents’ marginal rate rather than their own, likely lower, rate. Keep this in mind before transferring assets to them.
Saving for education
Coverdell Education Savings Accounts (ESAs) and 529 savings plans offer parents (or anyone else, such as grandparents) a tax-smart way to fund education expenses:
- Contributions aren’t deductible for federal purposes, but plan assets grow tax-deferred.
- Distributions used to pay for qualified expenses — such as tuition, mandatory fees, books, equipment, supplies and, generally, room and board — are income-tax-free for federal purposes and may be tax-free for state purposes.
- You remain in control of the account — even after the child is of legal age.
- You can make rollovers to another qualifying family member.
There's also now more certainty about the benefits of ESAs going forward. (See “What’s new! Valuable ESA benefits made permanent.”) Which plan is better depends on your situation and goals. You may even want to set up both an ESA and a 529 plan for the same student.
529 plan pluses and minuses
For many taxpayers, 529 plans are better than ESAs because they typically offer much higher contribution limits (determined by the sponsoring state). Plus, there are no income-based limits for contributing — and there’s generally no beneficiary age limit for contributions or distributions. Finally, your state may offer tax benefits to residents who invest in its own 529 plan.
With a prepaid tuition plan, if your contract is for four years of tuition, tuition is guaranteed regardless of its cost at the time the beneficiary actually attends the school. The downside is that there’s uncertainty in how benefits will be applied if the beneficiary attends a different school.
A college savings plan, on the other hand, can be used to pay a student’s expenses at most postsecondary educational institutions. Distributions used to pay qualified expenses (such as tuition, mandatory fees, books, equipment, supplies and, generally, room and board) are income-tax-free for federal purposes and typically for state purposes as well.
The biggest downside may be that you don’t have direct control over investment decisions; you’re limited to the options the plan offers. Additionally, for funds already in the plan, you can make changes to your investment options only once during the year or when you change beneficiaries. For these reasons, some taxpayers prefer Coverdell ESAs. (See “What's new! Valuable ESA benefits made permanent.”)
But each time you make a new contribution to a 529 savings plan, you can select a different option for that contribution, regardless of how many times you contribute throughout the year. And you can make a tax-free rollover to a different 529 plan for the same child every 12 months.
Jumpstarting a 529 plan
To avoid gift taxes on 529 plan contributions, you must either limit them to $14,000 annual exclusion gifts or use up part of your lifetime gift tax exemption. Fortunately, a special break for 529 plans allows you to front-load five years’ worth of annual exclusion gifts and make a $70,000 contribution (or $140,000 if you split the gift with your spouse). And that’s per beneficiary.
If you’re a grandparent, this can help you achieve your estate planning goals. (See the Case Study “A 529 plan can be a powerful estate planning tool for grandparents.”)
If you have children in college or are currently in school yourself, you may be eligible for a credit:
American Opportunity credit. This 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. The credit had been scheduled to revert to the less beneficial Hope credit in 2013, but ATRA extends the American Opportunity credit through 2017.
Lifetime Learning credit. If you’re paying postsecondary education expenses beyond the first four years, check whether you’re eligible for the Lifetime Learning credit (up to $2,000 per tax return).
Both a credit and a tax-free 529 plan or ESA distribution can be taken as long as expenses paid with the distribution aren’t used to claim the credit.
Be aware that income-based phaseouts apply to these credits. (See the Charts “2013 family and education tax breaks: Are you eligible?” and “2014 family and education tax breaks: Are you eligible?”) If you don’t qualify for one of the credits because your income is too high, your child might. However, you must forgo your dependency exemption ($3,900 for 2013; $3,950 for 2014) for the child (and the child can’t take the exemption).
But because of the return of the exemption phaseout (see “What’s new! Deduction reduction and exemption phaseout are back”), you might lose the benefit of your exemption anyway. So this may be an easy decision.
If you don’t qualify for one of the credits, you might be eligible to deduct up to $4,000 of qualified higher education tuition and fees — but note that ATRA extended this break, which had expired after 2011, only through 2013. The deduction is limited to $2,000 for taxpayers with incomes exceeding certain limits and is unavailable to taxpayers with higher incomes. Check with your tax advisor for the 2013 income limits, and check back here to learn if Congress extends the deduction to 2014 or beyond. Warning: You can’t claim the deduction for the same year you claim an education credit or if anyone else is claiming an education credit for the same student for the same year.
If you’re paying off student loans, you may be able to deduct up to $2,500 of interest (per tax return). An income-based phaseout applies. (See the Charts “2013 family and education tax breaks: Are you eligible?” and “2014 family and education tax breaks: Are you eligible?”) ATRA makes permanent various enhancements to the deduction that were scheduled to expire after 2012. Contact your tax advisor for details. •
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