Family Matters Tax Guide
Whether you have one child or ten, you should be aware of the tax savings Uncle Sam offers.
January 2007
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Family values can really pay off at tax time. Four children younger than 17 can reduce your tax bill by at least $17,200. And that's just counting exemptions and the child tax credit. Your kids could cut your taxes even more if you've participated in a dependent-care flexible savings account or take the dependent-care credit.
We don't advocate building your family just to reduce your taxes. But you need to be aware of the savings Uncle Sam offers. Parents need to be aware that children might have to file returns of their own if they had investment earnings or earned income. Here are some issues to keep an eye on:
- Standard deductions
- Claiming dependents
- Child credit
- Child- and dependent-care credit
- Adoption credit
- Nanny tax
- Head of household
- Kids and taxes
- Reporting a child's income
- Health savings accounts
Standard deductions
The annual adjustment for inflation boosts the standard deduction for couples to $10,300 plus $1,000 for each spouse age 65 or older. Singles get $5,150 plus $1,250 for those 65 and older. Heads of household get $7,550 plus $1,250 once they're 65. The federal tax brackets also are wider (see the table below).
Claiming dependents
You are allowed one exemption -- $3,300 on 2006 income tax returns -- for each person you claim as a dependent. You must provide a valid social security number for each dependent claimed. Also, the dependency exemption phases out as adjusted gross income rises above $225,750 for married couples, $188,150 for heads of household, $150,500 for singles and $112,875 married people filing separately.
To claim someone as a qualifying child, four tests must be met:
The child must be your child (including an adopted child, stepchild or foster child), a brother, sister, stepbrother, stepsister or descendant of one of these relatives.
The child must live with you for more than half a year.
The child must be younger than a certain age. For the dependency exemption, head of household filing status and the earned income credit, the child must be younger than 19 at the end of the year, 24 if a student or any age if permanently and totally disabled. For the child tax credit, the child must be younger than 17. For the dependent care credit, the child must be younger than 13, or any age if permanently and totally disabled.
The child cannot have provided more than half of his or her own support.
To claim the dependency exemption for a child, the child also must be a citizen of the United States, a U.S. national, or a resident of the U.S., Canada or Mexico.
To claim the dependency exemption for a relative who is not a qualifying child, the person must meet five tests.
The person must either live with you for the entire year or be related to you.
The person must be a citizen of the United States, resident alien, or a resident of Canada or Mexico.
Usually you cannot claim someone who has filed a joint tax return (someone who is married).
You cannot claim someone who had gross income of $3,300 or more for 2006.
You no longer have to provide more than half of his or her support if the person doesn't pay more than 50% of his or her own support.
Child credit
The child credit is worth up to $1,000 for each dependent younger than 17 at the end of 2006. You must file a form 1040 or 1040A to claim the credit. You cannot claim the credit if you file a 1040-EZ.
The credit is phased out as adjusted gross income exceeds $110,000 on a joint return, $75,000 on a single return. The credit is reduced by $50 for every $1,000 above those amounts. For example, if you're married and your AGI is $112,000, your credit would be limited to $900.
The credit can also be limited by the amount of tax you owe, or any alternative minimum tax you owe. See IRS Publication 972, Child Tax Credit, for details.
Credits (and exemptions, explained above) are much more valuable than deductions. Credits are subtracted from the taxes you owe dollar-for-dollar. Deductions are subtracted from your adjusted gross income before taxes are applied. So, for example, if you earn $100,000 in the 25% tax bracket, you would owe -- in the simplest terms -- $25,000 in taxes. A $4,000 child tax credit would cut your tax bill to $21,000. (A $4,000 deduction reduces your taxable income to $96,000. Your tax bill is reduced to $24,000.)
Child- and dependent-care credits
Taxpayers can claim a credit for child- and dependent-care expenses -- up to $3,000 in expenses for an individual, $6,000 for two or more.
Qualified dependents include:
Dependents under age 13
Dependents who are physically or mentally unable to care for themselves
Spouses who are physically or mentally unable to care for themselves
To claim the credit for a child, both parents must have earned income, unless one spouse is a full-time student. Also, you must report the name, address, and taxpayer identification number, (either the social security number, or the employer identification number) of the care provider on your return, unless the care provider is tax exempt.
Your adjusted gross income will determine what percentage of the $3,000 or $6,000 in qualified expenses you can actually claim as a credit.
For example, if your AGI exceeds $43,000, you're credit is only 20% of the maximum $6,000 -- or $1,200. You will calculate your credit amount using Schedule 2 of Form 1040A, or Form 2441 with Form 1040.
The calculation can get tricky if you receive employer benefits that allow you to set aside pre-tax earnings for dependent care. Expenses covered or reimbursed by your employer's flexible-spending plan can't be claimed. Because the maximum you can set aside in an employer's benefit plan is $5,000 and the most you can claim for the credit is only $6,000, the dependent-care benefit usually wipes out most of the credit.
Even if you don't set aside or use the entire $5,000 allowable in a benefit plan and want to claim a portion of the child credit, it's better to pick one or the other to avoid future frustration. Figure which option gives you the most tax savings and go with it.
If you're eligible for both, it's generally better to use your flex plan rather than the child-care credit. Check out our How Much Should I Put in my Flexible-Spending Account? calculator to see how much your contributions will lower your tax bill. This calculator can also help you figure out how much money to set aside in your flexible-spending account for medical expenses.
Adoption credit
The credit can be taken on qualified expenses up to $10,960 -- an increase of $330. The credit phases out for filers with AGIs between $164,410 and $204,410.
Nanny tax
It nailed Bernard Kerik, the former NYPD chief and would-be Department of Homeland Security secretary. It also nabbed Zoe Baird, President Clinton's first choice for Attorney General. But you don't have to be a presidential appointee to get into trouble for ignoring the so-called nanny tax.
The nanny tax is actually a combination of medicare, social security, unemployment and state taxes, and reporting these obligations is widely ignored. First, because many people don't realize they are employers when they hire someone to watch the kids or help around the house. Second, it's hard to get caught.
So why should you bother?
If you owe the taxes, ignoring them means you're breaking the law. If you're caught, you are liable for back taxes -- your share and the employee's -- plus interest and penalties.
Here's how it breaks down:
If you pay an individual more than $1,500, you must withhold your employee's share of social security and medicare taxes (7.65%) and pay the employer's share (7.65%).
You must pay the federal unemployment tax if you pay more than $1,000 in a quarter to an employee. The tax is 6.2% of wages up to $7,000, but you'll get a credit for paying state unemployment taxes that lowers the federal rate to 0.8%
Even if you don't owe federal taxes, you may be liable for state unemployment and disability insurance. See our Taxes page for links to your state tax agency.
You don't have to count wages paid to your spouse, parent, your child younger than 21 or an employee younger than 18.
You are not required to withhold federal income taxes -- unless your employee asks you.
You can pay your share of taxes when you file your annual tax return by filling out a Schedule H or by making quarterly estimated tax payments with Form 1040-ES. For more information, see Publication 926, Household Employer's Tax Guide.
Head of household
You may qualify for head-of-household filing status if you are a single person providing more than half the cost of keeping up the principal home for yourself and your unmarried child.
Divorced or widowed parents may get some help from Uncle Sam if a single child returns home -- after college, say, or following a divorce.
This gets you a bigger standard deduction -- $7,550 in 2006 -- and lower tax rates.
Usually, to qualify as a head of household, you must be providing a home for a person who is your dependent. And, generally, anyone who made more than $3,300 in 2006 can't qualify as a dependent. But when your single child is involved, the dependency test doesn't matter. So, no matter how much your son or daughter made, you might still qualify for the head of household tax break. Check it out. See IRS Publication 17, Your Federal Income Tax, page 22, for details.
Kids and taxes
Have a budding Donald Trump on your hands? Your child's initiative might just be rewarded with an introduction to the IRS. Children may be required to file a tax return if:
They have bank, mutual fund or brokerage accounts in their names, and earned more than $1,700 in investment income during the year.
They had a job last year -- anything from babysitting to delivering papers to more serious pursuits -- earned more than $5,000.
They had unearned income of $250 or less with gross income of more than $5,000, or unearned income of $250 or more with gross income of more than $800.
Now, your child might want to file a return even if the law does not demand it. It's the only time to retrieve taxes withheld from paychecks.
Although kids often can get most or all of their income taxes back, many teens are often surprised -- and disappointed -- to learn that that rule doesn't apply to social security taxes withheld by the boss. There's no way to get that money back until you retire and file for benefits.
Reporting a child's income
Congress allows parents of children younger than 18 to report the child's income on the parents' return -- rather than having to file a separate return for the child. This is permitted if the child's income is solely from interest and dividends (including capital gains distributions from a mutual fund) and is less than $1,700.
That might sound good, but you'll be better off saying "Thanks, but no thanks." It will probably be easier to fill out a return for your child. The short Form 1040A will suffice if your child's income would qualify to be reported on your return.
Form 8814 -- which you must file with your own return if you include your child's income -- is a hassle to complete. And, reporting a kid's income on your return can cost the family money.
On the 8814 form, for example, up to $850 of capital gains distributions or dividends that might be taxed at 5% on the child's return is sure to be taxed at 10%. If the parents owe an underpayment penalty, adding the child's income (and tax liability) to their return can make things worse. And, if the parents' income is high enough to cause a squeeze on the child credit, IRA deductions or the value of exemptions or itemized deductions, adding a child's income will tighten the vise.
However, if your child's investment income is more than $1,700, adding his or her income to your return will allow you to avoid completing the Form 8615, where you figure the "kiddie tax" for children younger than 18. On unearned income in 2006, there is no tax on the first $850 of investment income and the next $850 is taxed at the child's rate. The kiddie tax applies the parents' tax rate to the child's income in excess of $1,700. Reporting the child's income on your return will automatically take care of that.
But, even if you have to mess with the kiddie tax, you'll probably find it easier to complete a 1040A and Form 8615 for your child, rather than using the Form 8814 to add the child's income to your return.
Health savings accounts
If you signed up for a high-deductible health insurance policy and teamed it with a health savings account to pay the bills, you can deduct what you loaded in the HSA.
In general, you can contribute up to the amount of your deductible, or $5,450 for families ($2,700 for singles), whichever is less. Those 55 and older can deduct an additional $700. Your annual contribution, and deduction, is also limited by the date you open your HSA. If you opened the account on May 1, for example, you would only be eligible to contribute up to $2,270.83, or five-twelfths of the maximum.
The upside is you don't have to itemize to get this deduction.
Almost anyone younger than age 65 who buys a qualified health insurance policy with a deductible of at least $1,050 for individuals, $2,100 for families, can open an HSA.
You can use the money tax-free for medical expenses, and anything left over grows tax-deferred. You can use the money for anything after age 65 without penalty, but you will owe income taxes on any money that isn't used for medical expenses.
In many cases, the cost savings from buying a high-deductible policy make up for the higher out-of-pocket medical expenses you'll have to pay -- not to mention the tax benefits.
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