Aside from claiming your child as a dependent on your taxes, the two biggest tax breaks in this category are the dependent-care credit and the child tax credit. If you pay for baby-sitting or day care for a child under 13, you can claim a tax credit if you and your spouse both work or if one parent is a full-time student or disabled. A single parent with earned income is also eligible.
The credit is calculated on a sliding scale of 20 percent to 30 percent of $2,400 of eligible costs ($4,800 for two or more children). For example, if you pay $4,000 a year for day care for a six-year-old child and your adjusted gross income is $30,000, you can take a credit of 20 percent of the first $2,400 of expenses, or $480.
If you are in the 28 percent tax bracket (taxable income over $43,850 for a couple or $35,150 for a head of household), you are better off participating in an employer-sponsored dependent care savings plan and skipping the credit. These plans allow you to pay dependent-care costs with dollars that are free from federal, state and Social Security taxes, up to $5,000 a year. If you only have one eligible child, participating in an employer plan is usually smarter no matter what your tax bracket because the dollar limit is higher.
More things to consider:
- If you are divorced, only the custodial parent can claim the dependent-care credit.
- Nursery school and kindergarten costs are usually eligible, but private-school expenses in first grade or higher are not.
- Overnight camp expenses are not eligible but day camp expenses are, as long as the cost is about the same as other forms of day care.
- The $500 child credit is available for children under 17 and starts to phase out at $110,000 adjusted gross income for couples, $75,000 for singles and heads of household and $55,000 for a married person filing separately.
- A married couple whose joint income exceeds the limit may be able to take advantage of the credit by filing separately. Just remember that filing separately will exclude you from other benefits such as the Roth IRA.
The Kiddie Tax
Parents often give stocks, bonds or mutual funds to their children in order to save taxes on their own return. Unless your child stars in her own sitcom, she is probably in a lower tax bracket, so she'll pay less tax on investments than you will.
However, the IRS is wise to this tactic. So beware of the kiddie tax. If your child is under 14, the first $700 of unearned income (dividends, interest, capital gains) is free of tax, and the next $700 is taxed at her rate. All investment income above that amount is taxed at your (the parents') rate. The child can file a separate return, or you can file the income on your own return.
After age 14, the kiddie tax disappears and all investment income is taxed at the child's rate. There is no kiddie tax for money earned on a job; your child will only pay taxes on earned income above $4,300.
If your child is younger than 18 (or 21 in some states), investments in her name must be held in a custodial account (also called an UGMA or UTMA account). An adult -- often the parent -- is the custodian and controls the investment, but the proceeds can only be used for "extras" for the child such as private-school tuition, music lessons, camp and so on. It is not legal to charge your child room and board in order to get at the money.
The advantage of custodial accounts is the tax break, but there are lots of drawbacks. Control shifts to the child when she is 18 or 21. Even if the money is earmarked for college, the child may decide to cash in the investments and travel the world or snap up that red Miata she's had her eye on. Investments in the child's name may make her ineligible for financial aid.
Instead of holding investments in your child's name, consider keeping them in your own name and gifting them to your child when you're sure she's headed for college and hasn't qualified for financial aid. She can cash them in and pay taxes at her own (lower) rate.
If you are self-employed (and your business is not incorporated), consider hiring your child to work for you. The work must be bona fide and business-related like filing, copying, or cleaning the office and the wage must be reasonable. If your child is under 18, she is exempt from Social Security, Medicare and unemployment tax, and the money you pay her is a deductible business expense. Plus, the child's income for the year or $2,000, whichever is less, can be set aside in a Roth IRA for a college or new house fund or a big head start on a retirement nest egg.
The tax breaks that got a big buzz when introduced in 1998 were the Hope and Lifetime Learning credits. The Hope credit applies to the first two years after high school and allows for a credit up to 100 percent of the first $1,000 of tuition and 50 percent of the next $1,000 for a total of $1,500. You can take a Hope credit for each eligible child.
The Lifetime Learning credit of 20 percent of up to $5,000 of qualified tuition expenses applies to undergraduate, graduate, and professional coursework as well as for students acquiring or improving job skills. Only one credit is available per family. Both credits phase out completely if your income is over $100,000 (married) or $50,000 (single or head of household).
If your income is too high to claim the Hope or Lifetime Learning credit and your child had substantial earned income, she may be able to take the credit instead. However, neither of you will be able to claim her as an exemption.