Changing focus for tax savings
When it comes to family and education, much of the focus in 2020 has been on the impact of the COVID-19 crisis, whether it’s finding daycare, managing remote learning or simply having the entire family home nearly 24-7 for extended periods. But it’s also an important year to be sure you and your family take advantage of available credits, deductions and other tax-saving opportunities.
Through 2025, the TCJA expands tax credits for families, doubling 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, so for many taxpayers these expanded credits have been making up for the TCJA’s suspension of dependency exemptions:
- 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. (See the charts “2020 Child and education breaks: Are you subject to a phaseout?” and “2021 Child and education breaks: Are you subject to a phaseout?”.) So more taxpayers are now benefiting from the credit.
- For each qualifying dependent other than a qualifying child (such as a dependent
child age 17 or older or a dependent elderly parent), a $500 family credit is now available. But it’s also subject to the income-based phaseout.
The American Rescue Plan Act enhances the child credit for 2021:
- It raises the eligibility age to under age 18 at the end of 2021.
- It increases the credit to $3,000 per child, and to $3,600 per child under age 6 at the end of 2021.
However, the increased credit amount ($1,000 or $1,600) is subject to lower income phaseout. (See the chart “2021 Child and education breaks: Are you subject to a phaseout?”.)
ARPA also requires the IRS to provide taxpayers the option to receive advance payments (generally by direct deposit) equaling 50% of the IRS's estimate of the taxpayer's 2021 child tax credit. These payments will be made July 2021 through December 2021.
If you adopt, you may qualify for the adoption credit — or for an employer adoption assistance program income exclusion. Both are $14,440 for 2021 (up from $14,300 for 2020), but the credit is also subject to an income-based phaseout. (See the charts “2020 Child and education breaks: Are you subject to a phaseout?” and “2021 Child and education breaks: Are you subject to a phaseout?”.)
Finally, if you qualified for an Economic Impact Payment for a child under the CARES Act but didn’t receive it, you can claim a credit for it on your 2020 income tax return.
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.
For 2021, ARPA increases the credit to 50% of up to $8,000 in qualified expenses for one child and up to $16,000 for two or more children — so the credit ultimately is worth up to $4,000 or $8,000. The credit is subject to an income-based phaseout beginning at household income levels exceeding $125,000.
FSA. Under ARPA, for 2021, you can contribute up to $10,500 (up from $5,000 for 2020) 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. In response to the COVID-19 crisis, the IRS has temporarily made FSAs a little more flexible. Contact your employer for details.
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 ($12,400 for 2020 and $12,550 for 2021) and pay zero federal income tax. They can earn an additional $6,000 annually for 2020 and 2021 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.
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 have so much time to let their accounts grow tax-deferred or tax-free.
The 2020 and 2021 annual contribution limits are the lesser of $6,000 or 100% of earned income. 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). The TCJA had made the kiddie tax harsher, taxing income subject to the tax according to the tax brackets used for trusts and estates.
Before 2018, such income was generally taxed at the parents’ tax rate. In many cases, the TCJA would have caused children’s unearned income to be taxed at higher rates than their parents’ income, because higher rates kick in at much lower income levels for trusts and estates.
Fortunately, the federal spending package signed into law in December of 2019 returned the kiddie tax to pre-TCJA law, retroactive to 2018. If your family paid the kiddie tax for 2018 under the TCJA rules, you might be eligible for a refund for a portion of that tax.
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.
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 SECURE Act further expands 529 plans by allowing them to be used to pay up to $10,000 of student loans 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 ($15,000 for 2020 and 2021) 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 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. (See the charts “2020 Child and education breaks: Are you subject to a phaseout?” and “2021 Child and education breaks: Are you subject to a phaseout?”.)
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 “2020 Child and education breaks: Are you subject to a phaseout?” and “2021 Child and education breaks: Are you subject to a phaseout?”.) 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. (See the charts “2020 Child and education breaks: Are you subject to a phaseout?” and “2021 Child and education breaks: Are you subject to a phaseout?”.)
If your employer pays some of your student loan debt and the payment is made before Jan. 1, 2021, the CARES Act may allow you to exclude up to $5,250 from income. The Consolidated Appropriations Act (CAA) extends this break through 2025. Student loan repayments for which the exclusion is allowable can't be deducted.
Finally, ARPA requires the tax-free treatment of student loan debt forgiven between Dec. 31, 2020, and Jan. 1, 2026. Forgiven debt typically is treated as taxable income.
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 ($15,000 for 2020 and 2021).