Turn saving taxes into a family tradition
Raising children and helping them pursue their educational goals — or pursuing your own — can be highly rewarding. But it also can be
expensive. Fortunately, a variety of tax breaks can offset some of the costs. Be sure you and your family take advantage of all credits, deductions and other breaks that are available to you and turn saving taxes into a family tradition.
Under the TCJA, these two tax credits for families are available through 2025:
- For each child under age 17 at the end of the tax year, 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 than before the TCJA. So more taxpayers are now benefiting from the credit. And, up to $1,500 of the credit is refundable.
- For each qualifying dependent other than a qualifying child (such as a dependent
child over the age limit or a dependent elderly parent), you may be able to claim a $500 family credit. But it’s also subject to the income-based phaseout.
The enhancement to the child credit under the American Rescue Plan Act (ARPA) expired at the end of 2021, though there has been some talk in Congress of reviving them.
If you adopt, you may qualify for the adoption credit — or for an employer adoption assistance program income exclusion, up to the applicable limit, but the credit is also subject to an income-based phaseout.
A couple of tax breaks can help offset the costs of dependent care:
Child and dependent care 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.
Child and dependent care FSA. You can contribute up to the annual limit 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. If they max out their contributions to a traditional IRA, they can earn an additional amount up to the annual contribution limit without owing current tax. Warning: They must perform actual work and be paid in line with what you’d pay nonfamily employees for the same work.
One of the best ways to get children on the right financial track is to set up IRAs for them. Their retirement may seem too far off to warrant saving now, but IRAs can be perfect for teenagers precisely because they likely will have many, many years to let their accounts grow tax-deferred or tax-free.
A teen’s traditional IRA contributions typically are deductible, but distributions will be taxed. Roth IRA contributions aren’t deductible, but qualified distributions will be tax-free. (See the Case Study “Why Roth IRAs are tax-smart for teens.”)
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 most unearned income of children under age 19 and of full-time students under age 24 (unless the students provide more than half of their own support from earned income). Such income is generally taxed at the parents' tax rate.
The purpose of the kiddie tax is to minimize the ability of parents to significantly reduce their family’s taxes by transferring income-producing assets to their children in lower tax brackets. Keep the kiddie tax in mind before transferring income-producing assets to children (or grandchildren) who’d be subject to it.
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. One downside is that there’s uncertainty in how benefits will be applied if the beneficiary attends a different school. Another is that the plan doesn’t cover costs other than tuition, such as room and board.
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 the following expense are income-tax-free for federal purposes and potentially also for state purposes, making the tax deferral a permanent savings:
- Qualified postsecondary school expenses, such as tuition, mandatory fees, books, supplies, computer equipment, software, Internet service and, generally, room and board,
- Elementary and secondary school tuition of up to $10,000 per year per student, and
- Up to $10,000 of student loan debt per beneficiary.
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 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 into a 529 plan contribution in a single year. 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.”)
Some parents and grandparents have hesitated to contribute to 529 plans — or to make large contributions to them — because of the potential tax consequences if the beneficiary doesn’t go to college, earns scholarships and grants to cover college costs, or simply doesn’t need the entire balance for college expenses.
Currently, when 529 plan beneficiaries don’t use up all of their 529 plan funds on qualified education expenses, the options are generally limited to either making a tax-free rollover to a 529 plan for another qualifying family member or paying income tax and a 10% penalty on the portion of nonqualified withdrawals attributable to earnings (though, unlike with ESAs, there’s no time limit on when funds must be withdrawn).
But a new option will be available starting in 2024 — up to $35,000 in unused 529 plan funds can be rolled into a Roth IRA for the beneficiary, subject to various rules:
- The 529 plan must have been set up for at least 15 years.
- No contributions from the last five years (or earnings on them) can be rolled over.
- The rollovers are generally subject to the Roth IRA annual contribution limits — but not the AGI-based phaseout.
IRS guidance on the new provision is expected. Check with your tax advisor for the latest information.
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.
ESAs are worth considering if you want to fund elementary or secondary education expenses in excess of $10,000 per year or that aren't tuition, or if you 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.
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. The phaseout ranges used to be much lower for the Lifetime Learning credit, but the Consolidated Appropriations Act (CAA) signed into law in December 2020 increased them to match the American Opportunity credit ranges. If you don’t qualify for one of the credits on your tax 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.
If your employer pays some of your student loan debt, you may be eligible to exclude up to $5,250 from income. (Student loan interest payments for which the exclusion is allowable can’t be deducted.) This break is scheduled to expire after 2025. Student loan repayments for which the exclusion is allowable can't be deducted.
Forgiven debt is typically treated as taxable income, but tax-free treatment is available for student loan debt forgiven after Dec. 31, 2020, and before Jan. 1, 2026. Warning: Some states may tax such forgiven debt.
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.
Under the TCJA, 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 ABLE account annual rollover and contribution limit.