Make tax planning a family affair
Many tax breaks are available to families. Whether it’s a tax credit or tax-advantaged savings opportunity, or it’s for child care or education expenses, there’s something for just about everybody. And by making tax planning a family affair, you not only can save taxes, but also teach children from an early age the value of earning and saving money.
Tax credits
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. But the credit phases out for higher-income taxpayers; check with your tax advisor for details.
- 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. The maximum credit is generally 20% of eligible expenses, which is $600 for one dependent and $1,200 for more than one dependent.
- If you adopt, you may be able to take a credit or use an employer adoption assistance program income exclusion; both are limited to $13,360 for 2011 but to only $12,650 for 2012. This is because a tax law provision that allowed the larger credit or income exclusion for 2011 doesn't apply to 2012. So the credit returns to being inflation-adjusted based on a $10,000 limit that previously applied. An income-based phaseout also applies.
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 ($5,800 for 2011 and $5,950 for 2012) and pay zero federal income tax. They can earn an additional $5,000 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 2011 and 2012 contribution limits are the lesser of $5,000 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 ($5,800 for 2011 and $5,950 for 2012) and has no unearned income, he or she will pay zero federal income tax anyway. If a child earns more than 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. (See the Case Study “Traditional vs. Roth IRA: Which is better for a teen?”)
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 $1,900 (for 2011 and 2012) 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.
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.
ESA pluses and minuses
Perhaps the biggest ESA advantage is that you have direct control over how and where your contributions are invested. Another significant advantage is that tax-free distributions aren’t limited to college expenses; they also can fund elementary and secondary school costs. Warning: If Congress doesn't act to extend this treatment, distributions used for precollege expenses will be taxable starting in 2013.
A major disadvantage of ESAs is that the annual ESA contribution limit per beneficiary is relatively low — only $2,000 for 2011 and 2012, and contributions are further limited based on income. Warning: The annual contribution limit is scheduled to go down to $500 beginning in 2013.
Generally, contributions can be made only for the benefit of a child under age 18. Amounts left in an ESA when the beneficiary turns 30 generally must be distributed within 30 days, and any earnings may be subject to tax and a 10% penalty.
529 plan pluses and minuses
529 college savings plans can be used to pay a student’s qualified expenses at most postsecondary educational institutions. (Be aware that the provision that expanded the definition of “qualified expenses” to also include computers, computer technology and Internet service expired after 2010.)
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.
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.
But each time you make a new contribution, 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.
529 plans also are available in the form of a prepaid tuition program. 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 main downside of prepaid tuition plans is that there’s uncertainty in how benefits will be applied if the beneficiary attends a different school.
Your state may offer tax benefits to residents who invest in its own 529 savings plan or prepaid tuition program.
Jumpstarting a 529 plan
To avoid gift taxes on 529 plan contributions, you must either limit them to $13,000 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 $65,000 contribution (or $130,000 if you split the gift with your spouse). And that’s per beneficiary.
If you’re a grandparent, this can be a powerful estate planning strategy.
Education credits
When your child enters college, you may be able to claim the American Opportunity credit (an expanded version of what was previously known as the Hope credit). It covers 100% of the first $2,000 of tuition and related expenses and 25% of the next $2,000 of expenses. The maximum credit is $2,500 per year for the first four years of postsecondary education, but an income-based phaseout applies. The credit has been extended through 2012.
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). An income-based phaseout also applies.
Both a credit and 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.
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 for the child (and the child can’t take the exemption). Before 2010, your dependency exemption might have been partially phased out based on your income anyway, so this decision may have been an easy one. But through 2012, that income limit has been lifted. So you’ll need to work with your tax advisor to see whether the exemption or the credit will provide more tax savings overall for your family.
Education-related deductions
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. The deduction is limited to $2,000 for taxpayers with incomes exceeding certain limits and is unavailable to taxpayers with higher incomes. Warning: This break has been extended only through 2011.
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. •
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