Turn saving tax dollars into a family tradition
2016 may be another good year for families to save taxes. Most of the child- and education-related tax breaks on the table the last several years are available once again to parents — or in some cases to grandparents or to students themselves. And a new savings opportunity is now available for people with disabilities and their families. See "What's new! ABLE accounts offer a tax-advantaged way to fund disability expenses."
Make sure that you and your family are taking advantage of the credits, deductions and other tax-saving opportunities that apply to you. Savvy, strategic tax-related decision-making can become a family tradition, if it’s not already.
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:
- 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 percentage 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 percentage but don’t phase it out altogether.
- If you adopt, you may be able to take a credit or use an employer adoption assistance program income exclusion; both are limited to $13,400 for 2015 ($13,460 for 2016). An income-based phaseout also applies.
For more information on the income-based phaseouts that apply to these credits, see the Charts “2015 family and education tax breaks: Are you eligible?” and “2016 family and education tax breaks: Are you eligible?”.
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.
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 ($6,300 for 2015 and 2016) and pay zero federal income tax. They can earn an additional $5,500 annually in 2015 and 2016 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 can be perfect for teenagers because they likely have many years to let their accounts grow tax-free. (See the Case Study “Roth IRAs: A powerful savings tool for teens.”)
The 2015 and 2016 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 ($6,300 for 2015 and 2016) 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 up to the amount they’re eligible to contribute — but keep the gift tax in mind.
Section 529 plans provide another valuable tax-advantaged savings opportunity. You can choose a prepaid tuition plan to secure current tuition rates or a tax-advantaged savings plan to fund college expenses. Here are some of the possible benefits of such plans:
- Although contributions aren’t deductible for federal purposes, plan assets can grow tax-deferred. (Some states do offer tax incentives, in the form of either deductions or credits.)
- The plans usually offer high contribution limits, and there are no income limits for contributing.
- There’s generally no beneficiary age limit for contributions or distributions.
- You can control the account, even after the child is of legal age.
- You can make tax-free rollovers to another qualifying family member.
Whether a prepaid tuition plan or a savings plan is better depends on your situation and goals.
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, thus making the tax deferral a permanent savings.
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 twice during the year or when you change beneficiaries. (Before 2015, generally such changes were allowed only once a year or when beneficiaries were changed.) For these reasons, some taxpayers prefer Coverdell ESAs.
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.
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 up to 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.”)
Coverdell Education Savings Accounts (ESAs) are similar to 529 savings plans in that contributions aren’t deductible for federal purposes, but plan assets can grow tax-deferred and distributions used to pay qualified education expenses are income-tax-free.
One of the biggest ESA advantages is that tax-free distributions aren’t limited to college expenses; they also can fund elementary and secondary school costs. Another advantage is that you have more investment options. ESAs are worth considering if you want to fund elementary or secondary education expenses or would like to have direct control over how and where your contributions are invested.
But the $2,000 contribution limit is low, and contributions are further limited based on income. The limit begins to phase out at a modified adjusted gross income (MAGI) of $190,000 for married filing jointly and $95,000 for other filers. No contribution can be made when MAGI hits $220,000 and $110,000, respectively.
Also, amounts left in an ESA when the beneficiary turns age 30 generally must be distributed within 30 days, and any earnings may be subject to tax and a 10% penalty.
If you’d like to help your grandchildren (or other minors) fund their college education but you don’t want to be subject to the limitations of a 529 plan or an ESA, you can transfer cash, stocks and bonds to a Uniform Gifts (or Transfers) to Minors Act (UGMA/UTMA) account:
- Although the transfer is irrevocable, you maintain control over the assets, but only
until the age at which the UGMA/UTMA account terminates (age 18 or 21 in most states).
- The transfer qualifies for the annual gift tax exclusion.
But keep in mind that UGMA/UTMA accounts are less attractive from an income tax perspective than they used to be: 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 $2,100 for 2015 and 2016 is taxed at their parents’ marginal rate rather than their own, likely lower, rate. Keep this in mind before transferring income-generating assets to them, whether directly or via an UGMA/UTMA account.
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 be available only through 2017, but it now has been made permanent.
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 “2015 family and education tax breaks: Are you eligible?” and “2016 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 ($4,000 for 2015; $4,050 for 2016) for the child (and the child can’t take the exemption).
But because of the exemption phaseout, 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 alternatively be eligible to deduct up to $4,000 of qualified higher education tuition. This deduction expired Dec. 31, 2015, but it's now been extended through 2016. Warning: You couldn’t claim the deduction for the same year you claim an education credit or if anyone else claimed 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 “2015 family and education tax breaks: Are you eligible?” and “2016 family and education tax breaks: Are you eligible?”.)