Tax Planning for New Parents
The IRS offers some tax credits to help alleviate the cost of trying to raise a family.
The birth of a child guarantees major changes in your lives ... as parents and as taxpayers. Over the years, Congress has peppered the law with tax breaks to help American families. Considering the high cost of child rearing in the 21st century, you'll need all the help you can get.
Your key to tax benefits is getting a Social Security number. You'll need one for your child to claim him or her as a dependent on your tax return. Failing to report the number for each dependent can trigger a $50 fine and tie up your refund until things are straightened out.
You can request a Social Security card for your newborn at the hospital at the same time you apply for a birth certificate. If you don't, you'll need to file a Form SS-5 with the Social Security Administration and provide proof of the child's age, identity and U.S. citizenship.
If registering newborns strikes you as silly, keep in mind that the aim is to prevent taxpayers from claiming dependents they don't deserve (think parakeets and puppies). Apparently it's working. In the first year the government required the numbers, 7 million fewer dependents were claimed than the year before.
Claiming your son or daughter as a dependent will shelter $3,950 of your income from tax in 2014, saving you a quick $987.50 if you're in the 25% bracket. (The value of the exemption is reduced if your adjusted gross income exceeds $254,200 if you’re single or $305,050 if you file a joint return.) You get the full year's exemption no matter when during the year the child was born or adopted. There's a big catch here, however: If you're subject to the alternative minimum tax, exemptions don't count ... at all.
$1,000 Child Credit
A new baby also delivers a $1,000 child tax credit, and this is a gift that keeps on giving every year until your dependent son or daughter turns 17. You get the full $1,000 credit no matter when during the year the child was born.
Unlike a deduction that reduces the amount of income the government gets to tax, a credit reduces your tax bill dollar for dollar. So, the $1,000 child credit will reduce your tax bill by $1,000. The credit is phased out at higher income levels, beginning to disappear as income rises above $110,000 on joint returns and above $75,000 on single and head of household returns. For some lower-income taxpayers, the credit is "refundable," meaning that if it more than exceeds income tax liability for the year, the IRS will issue a refund check for the difference.
Adjust Your Withholding
Because claiming an extra dependent will cut your tax bill, it also means you can cut back on tax withholding from your paychecks. File a new W-4 form with your employer to claim an additional withholding "allowance." For a new parent in the 25% bracket, that will cut 2014 withholding — and boost take-home pay — by about $80 a month. You can also take the child credit cited above into account on your W-4, pushing withholding down even more.
If you are married, having a child will not affect your filing status. But if you're single, having a child may allow you to file as a head of household rather than using the single filing status. That would give you a bigger standard deduction and more advantageous tax brackets. To qualify as a head of household, you must pay more than half the cost of providing a home for a qualifying person — and your new son or daughter qualifies.
Earned Income Credit
For a couple without children, the chance to claim this credit disappears when income on a joint return exceeds $20,020 in 2014. Having a child, though, pushes the cut off to about $43,941 in 2014. The income cut off is even higher if you have two or more children.
Child Care Credit
If you pay for child care to allow you to work — and earn income for the IRS to tax — you can earn a credit worth between $600 and $1,050 if you're paying for the care of one child under age 13 or between $1,200 and $2,100 if you're paying for the care of two or more children under 13. The size of your credit depends on how much you pay for care (you can count up to $3,000 for the care of one child and up to $6,000 for the care of two or more) and your income. Lower income workers (with adjusted gross income of $15,000 or less) can claim a credit worth up to 35% of qualifying costs, and the percentage gradually drops to a floor of 20% for taxpayers reporting AGI more than $43,000.
Child-Care Reimbursement Account
You may have an even more tax-friendly way to pay your child-care bills than the child care credit: A child-care reimbursement account at work. These accounts, often called flex plans, let you and your spouse divert up to $5,000 a year of your salary into a special account that you can then tap to pay child-care bills. Money you run through the account avoids both federal income and Social Security taxes, so it could easily save you more than the value of the credit.
Some workers steer clear of reimbursement accounts because of the use-it-or-lose-it rule that requires you to agree to set aside a certain amount of money for the account at the beginning of the year and, if you fail to spend every dime on qualifying costs, you forfeit any balance at year end. However, it should be fairly easy to pinpoint your expected child-care costs. Plus, the tax benefits are so powerful that you can come out well ahead even if you wind up forfeiting some of your set-aside. (A recent change in the law allows companies to permit employees to carry over as much as $500 in a flex plan from one year to the next ... a move to soften the use-it-or-lose-it rule. Check to see if your firm has adopted this rule.)
You can't double dip, by using both the reimbursement account and the credit. But note that while the limit for flex accounts is $5,000, the credit can be claimed against up to $6,000 of eligible expenses if you have two or more children. So, even if you run $5,000 through a flex account, you could quality to claim the 20% to 35% credit on up to $1,000 more.
Although you generally can only sign up for a flex account during "open season," most companies allow you to make mid-year changes in response to certain "life events," and one such event is the birth of a child.
There's also a tax credit to help offset the cost of adopting a child. The credit is worth as much $13,190 in 2014. This credit phases out as adjusted gross income in 2014 rises from $197,880 and is completely phased out for taxpayers with modified adjusted gross income of $237,880 or more.
Save for College
It's never too early to start saving for those college bills. And it's no surprise Congress has included some tax goodies to help parents save. One option is a Section 529 state education savings plan. Contributions to these plans are not deductible on the federal tax return, but earnings grow tax free and payouts are tax free, too, if the money is used to pay qualifying college bills. (Many states give residents a state tax deduction if they invest in the state's 529 plan.)
Coverdell Education Savings Accounts (ESA) offer another way to generate tax-free earnings to pay for educational expenses. Regardless of how many people contribute, there is a $2,000 limit on how much can go into any beneficiary's account in one year. There is no deduction for deposits, but earnings are tax-free if used to pay for education expenses. You can use the money tax-free for elementary and high-school expenses, as well as college costs.
You may have heard about kid IRAs, and the fact that relatively small investments when a child is young can grow to eye-popping balances over many decades.
While that's true, there's a catch. You can't just open an IRA tax shelter for your newborn and start shoveling in the cash. A person must have earned income from a job or self-employment to have an IRA. Gifts and investment income don't count. So, you probably can't open an IRA for your newborn (unless, perhaps, he or she gets paid as an infant model).
As soon as your youngster starts earning some money — babysitting or delivering papers, for example, or helping out in the family business — he or she can open an IRA. The phenomenal power of long-term compounding makes it a great idea. Although a child must have earned income to have an IRA, the child's own money doesn't have to go into the account. It's fine for a generous parent or grandparent, for example, to give the child money for the account. Contributions are limited to $5,500 a year, or 100% of the child's earnings, whichever is less.
The graduated nature of the income tax rates — with higher tax rates on higher incomes — creates opportunities for savings if you can shift income to someone (a child, perhaps) in a lower tax bracket.
Let's say Dad has $1 million invested in bonds paying $50,000 of taxable interest each year. As a resident of the 39.6% tax bracket who is also hit with the 3.8% surtax on investment income, that extra income hikes his tax bill by $21,700. But, if he could divvy up the money among five children, each of whom earned $10,000 that would be taxed in the 10% bracket, the family could save $16,700 in tax.
Not So Fast
To prevent such shenanigans, Congress created the kiddie tax to tax most investment income earned by a dependent child at the parents' top tax rate. For 2014, the first $1,000 of a child's "unearned" income (that's income that's not earned from a job or self employment) is tax-free and the next $1,000 is taxed at the child's own rate (probably 10% for interest income or probably 0% for long-term capital gains and qualified dividends).
Any additional income is taxed at the parents' rate — as high as 39.6% plus the 3.8% surtax. The kiddie tax applies until the year a child turns 19, or 24 if he or she is a dependent full-time student.
If you hire someone to come into your home to help care for your new child, you could become an employer in the eyes of the IRS and face a whole new set of tax rules. If you hire your nanny or caregiver through an agency, the agency may be the employer and have to take care of all the paperwork. But if you're the employer — and you pay more than $1,900 a year in 2014 — you're responsible for paying Social Security and unemployment taxes for your caregiver, and reporting the wages you pay to the government on a W-2 form.