Can family and education breaks save you tax?
Raising children and helping them pursue their educational goals — or pursuing your own — can be highly rewarding. But it also can be expensive. So make sure that you and your family are taking advantage of the credits, deductions and other tax-saving opportunities that apply to you. Some have changed for 2018 under the Tax Cuts and Jobs Act (TCJA).
There are also other ways to promote a child’s strong financial future. For example, children need to understand the value of saving — and contributing to their own IRA can be both an educational and a tax-savings opportunity. Savvy, strategic tax-related decision-making can become a family tradition, if it’s not already.
Along with the personal exemption, the TCJA eliminates the dependent exemption ($4,050 per dependent for 2017) for 2018 through 2025. But it expands tax credits for families during that period, increasing the child credit and adding a new “family” credit for dependents who don’t qualify for the child credit.
Tax credits reduce your tax bill dollar for dollar, unlike exemptions which work similarly
to deductions. (See the Chart “Tax deductions vs. credits: What’s the difference for 2018?”)
Under the TCJA:
- For each child under age 17 at the end of 2018 or 2019, you may be able to claim a $2,000 credit. The credit still phases out for higher-income taxpayers, but the income ranges are much higher, so more taxpayers will benefit.
- For each qualifying dependent other than a qualifying child (such as a dependent child age 17 older or a dependent elderly parent), a new $500 credit is available, but it’s also subject to an income-based phaseout.
Another piece of good news for some parents is that the adoption credit and employer adoption assistance program income exclusions, which had been proposed for elimination under previous versions of the TCJA, ultimately survived. Both are $13,810 for 2018 ($14,080 for 2019), but the credit is subject to an income-based phaseout.
For more information on the income-based phaseouts that apply to these credits, see the Charts “2018 family and education tax breaks: Are you eligible?” and “2019 family and education tax breaks: Are you eligible?”.
A couple of tax breaks can help offset the costs of dependent care:
Tax credit. For children under age 13 or other qualifying dependents, you may be eligible for a credit for a portion of your dependent care expenses. Generally, the credit equals 20% of the first $3,000 of qualified expenses for one child or 20% of up to $6,000 of such expenses for two or more children. So, the maximum credit is usually $600 for one child or $1,200 for two or more children.
FSA. For 2018 and 2019, you can contribute up to $5,000 pretax to an employer-sponsored child and dependent care Flexible Spending Account. The plan pays or reimburses you for these expenses. You can’t claim a tax credit for expenses reimbursed through an FSA.
If you own a business, hiring your children can save tax. As the business owner, you can deduct their pay, and other tax benefits may apply. Children generally can earn as much as the standard deduction for singles and pay zero federal income tax. For 2018, it jumps to $12,000 under the TCJA ($12,200 for 2019). They can earn an additional $5,500 annually for 2018 ($6,000 for 2019) 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 2018 annual contribution limits are the lesser of $5,500 or 100% of earned income, reduced by any traditional IRA contributions. (The 2019 annual contribution limits are the lesser of $6,000 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 ($12,000 for 2018; $12,200 for 2019) 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 a low rate anyway. 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.
If you’d like to transfer assets to children or grandchildren, keep in mind the "kiddie tax." It generally 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).
New! The TCJA makes the kiddie tax harsher. Before 2018, unearned income subject to the kiddie tax was generally taxed at the parents’ tax rate. But for 2018-2025, a child’s unearned income beyond $2,100 for 2018 ($2,200 for 2019) will be taxed according to the tax brackets used for trusts and estates, which are taxed at the highest marginal rate of 37% once 2018 taxable income reaches $12,500 ($12,750 in taxable income for 2019). In contrast, for a married couple filing jointly, the highest rate doesn’t kick in until their 2018 taxable income tops $600,000 ($612,350 in taxable income for 2019). In other words, in many cases, children’s unearned income will be taxed at higher rates than their parents’ income.
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, any growth is tax-deferred. (Some states do offer breaks for contributing.)
- 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, supplies, computer equipment, software, Internet service, and, generally, room and board) generally are income-tax-free for federal and state purposes, thus making the tax deferral a permanent savings.
New! The TCJA has permanently expanded qualified expenses to include elementary and secondary school tuition. But tax-free distributions for such expenses are limited to $10,000 annually per student.
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. 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 your annual gift tax exclusion ($15,000 for 2018 and 2019) 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 $75,000 contribution (or $150,000 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 used to be that they allowed tax-free distributions for elementary and secondary school costs and 529 plans didn’t. With the TCJA enhancements to 529 plans, this is less of an advantage. But ESAs still have a leg up because they can be used for elementary and secondary expenses other than tuition — and there’s no dollar limit on such annual distributions. Another advantage is that you have more investment options.
ESAs are worth considering if you want to fund elementary or secondary education expenses in excess of $10,000 per year or beyond just tuition, 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. (See the Charts “2018 family and education tax breaks: Are you eligible?” and “2019 family and education tax breaks: Are you eligible?”.)
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 have children in college or are currently in school yourself, you may be eligible for a tax 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.
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 “2018 family and education tax breaks: Are you eligible?” and “2019 family and education tax breaks: Are you eligible?”.) If you don’t qualify for one of the credits on your 2018 return because your income is too high, your child might.
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 “2018 family and education tax breaks: Are you eligible?” and “2019 family and education tax breaks: Are you eligible?”.)
Achieving a Better Life Experience (ABLE) accounts offer a tax-advantaged way to fund qualified disability expenses for a beneficiary who became blind or disabled before age 26. For federal purposes, tax treatment is similar to that of Section 529 college savings plans. Aggregate contributions are generally limited to $15,000 for 2018 and 2019.
New! Under the TCJA, for 2018 through 2025, 529 plan funds can be rolled over to an ABLE account without penalty, as long as the ABLE account is owned by the beneficiary of the 529 plan or a member of the beneficiary's family. Such rolled-over amounts count toward the overall ABLE account annual contribution limit. Aggregate contributions are generally limited to $15,000 for 2018 and 2019.