Tax Planning: Kids and Taxes
It’s no secret. Having kids is expensive business.
Last year, I wrote about the real costs of raising a child and the numbers were staggering. According to the USDA, it nearly costs $240,000 to raise a child to birth to 17. Thankfully, when it comes to kids and taxes, they come with many tax advantages.
I have been through the whole paying for the delivery, buying diapers and wipes, and even the baby formula… twice.
However, I didn’t start feeling the financial pinch of raising a child until very recently. I have two boys. They’re 8 and 10 this year. I now have to give the “let’s go out for dinner” some serious thought. A family night out can cost us $60 to $75 for meals. Twelve months ago, I was ordering from the Kids Menu. Today, I have to order from the regular menu or my kids will go hungry.
Thankfully, when it comes time to filing my taxes there are some tax strategies to look forward to. Parents get substantial tax benefits in having children. But there are also some caveats to be mindful of.
Here are six important things that I’ve learned over the years when it comes to kids and taxes.
1. Dependency Exemption
You can claim a dependent exemption deduction of $4,050 for each child and dependent for 2016. Those exemptions reduce the part of your income that is subject to federal tax. If you’re in the 25% tax bracket, this may save you $1,1012.50. The higher your bracket, the more each dependency exemption saves you.
2. Child Tax Credit
You may also be eligible for a tax credit, which is even better than a deduction. Tax credits reduce your taxes dollar for dollar. The Child Tax Credit is an extra $1,000 credit you may be able to claim for children under 17.
3. Child and Dependent Care Credit
The Child and Dependent Care Credit is a great benefit. But don’t confuse it with a tax deduction. Again, tax credits reduce your taxes owed, dollar for dollar. If you paid someone to care for your child, spouse, or dependent last year, you may be able to use this credit.
Tax planning tip: You can claim this credit if you sent your kids to day camp in the summer. Overnight camps do not.
This credit is a dollar for dollar reduction of your taxes, based on your child care expenses. The Child and Dependent Care Credit can range from 20 to 35 percent of the dependent care expenses you paid. The actual percent you use depends on your Adjusted Gross Income (AGI). You can claim it for qualified yearly expenses up to $3,000 for one qualifying child or $6,000 for two or more children.
Any child who was under the age of 13 at the time of care qualifies. If your child turned 13 during the year, you can claim a portion of the credit during the year they were still under 13. If your spouse or dependent are unable to care for themselves, they can also receive the credit.
What child costs are eligible?
It’s important to note that not all care counts toward this wonderful credit. So what counts and what doesn’t?
If you pay for nursery school or preschool, that qualifies for the credit. Before- and After-school care can qualify as well. They are necessary for your child’s care while you’re at work. Unfortunately, overnight camps don’t qualify for the credit. They’re not considered a “work-related” expense. Yet, the cost of Summer Day Camps qualify as long as they provide care while the parent(s) are at work.
4. Dependent Care FSA
Some employers offer a Dependent Care Flexible Spending Account (Dependent Care FSA). It is a pre-tax employee benefit account. And it’s used to pay for dependent care services. You can use it to pay for preschool, summer day camp, before or after school programs, and child or elder daycare. It’s a smart, simple way to save money while taking care of your loved ones so that you can continue to work.
There is a caveat to using the Dependent Care FSA. You can only use either the Dependent Care FSA or take the Child and Dependent Care Credit. You can’t do both. For example, you can’t take a tax credit for expenses reimbursed by the FSA. That would be “double-dipping”.
Which should you use?
The Child and Dependent Care credit is more for those that earn LESS. And the Dependent Care FSA is best for those earning a moderate to high income.
The reasoning for this is that
If you’re earning a moderate to high income, your tax bracket will most likely be above 15% the threshold. Especially, if you are married and filing jointly (combining incomes with your spouse).
If you have one child, the $5,000 amount available through the Dependent Care FSA is more generous. The Child and Dependent Care credit only offers a $3,000 credit for a single child.
Finally, contributions to the Dependent Care FSA is pre-tax! Not only does it save you on income taxes (federal and state), but also Social Security taxes as well. There isn’t a social security tax savings offered by the Child and Dependent Care credit.
Use it or lose it
The money that you contribute the the Dependent FSA doesn’t roll over from year to year. You have to use it or you’ll lose it.
This isn’t such a bad thing since you know that you’re sending your child(ren) off to these places. It’s usually either that or not go to work. You have to just be careful not to over fund it. It’s not an investment account. The Dependent Care FSA is actually pretty neat program. If your employer offers one, consider yourself luck.
There is another caveat to be mindful of if you are divorce or unmarried. If you’re sharing custody, only one parent can claim the Child and Dependent Care Credit. If you have questions, speak to your tax advisor.
5. The “Nanny Tax”
I live a pretty busy life. My wife runs a business. And I run a couple of businesses. While we are working, we want to make sure our children are being cared for.
Over the years, we have assembled a militia of baby sitters. In many situations, each would come for a four hour stint while relieving the other. The process of vetting, scheduling and having them relieve each other was challenging. Also sitters age into college within a few short years.
For this reason, we have looked into hiring a part-time nanny on many occasions. Here’s what I discovered about hiring a nanny.
A nanny is a household employee as defined by the IRS. IRS Publication 926 lays out the specifics. But if you hire a nanny, you may need to pay state and federal employment taxes. Some states don’t collect income taxes.
If you pay cash wages of $2,000 or more for 2017 to any one household employee, you might get hit with the “nanny tax”. You’ll have to withhold 6.2% of social security and 1.45% of Medicare taxes (for a total of 7.65 percent) of cash wages. If you don’t, you’ll have to pay the 7.65 percent out of your own pocket. This includes payments made by check, money order, etc.
That’s not all. The sweet old lady across the street that you pay $50 a week to bring your kids to the bus stop so that you can go to work… Guess what? She counts. If you’re paying her $50 a week, totaling $2,000 a year, you owe the nanny tax.
The nanny tax extends to anyone who provides a service within your home. They are babysitters, nannies, and housekeepers. Repairmen and plumbers don’t count as they are contractors. But don’t try to pull one over the IRS. Paying your housekeeper under the table or giving them a 1099 is tax evasion.
Avoiding problems: A household worker may collect unemployment at some point. If they list your family as a place they worked, you could have a potential tax evasion case on you.
There are many more tax credits and deductions afforded to families with young kids. A fiduciary advisor can help with tax planning strategies that help you save money. Check out our Fiduciary Promise.
6. A final word on children
One of the most rewarding experiences in a parent’s life is sending a child to college. However, college has changed in the last fifteen years. And if all you’re doing is tucking money away into a 529 plan, you have a financial crisis in your future.
College is big business. There’s over $1.3 trillion in student loan debt. Next to mortgage debt, it’s the largest debt in America. That’s more than automotive and credit debt.. combined.
You may know this already, but it’s not likely that you’re going to save your way to college. It is likely that you will be in that $1.3 trillion dollar statistic. And that your child will have over $100,000 in student loan debt.
What you may not grasp right now is you’ll be at or near retirement when your last child graduates college. Can you remember if you co-signed those loans? Of course you did. Who’s going to give a kid a $100,000 line of credit for college without a co-signer? You might have even taken out a few PLUS loans yourself.
I say this not to scare you but to make a point.
College is expensive. But it gets out of control for those that do little to no financial planning for it. Keep in mind that there is no financial underwriting to take out student loans. Your kids can and will borrow as much as they want to fund their college life.
If you do your home work, you can:
- You can send your kids to a private college for as much as a public one
- Match your child to a career that they will most likely excel in
- Compare colleges against each other for financial and academic statistics
- Find private scholarship, grants and other tuition discounts
- Avoid the hopping from colleges
- Get a degree within 4 years, instead of 5 or 6
- Ensure all your children get equal college benefits
- You can also put together a game plan to get rid of the student loans
College is very important for many families. And I don’t know one family that wants to pay more for college than they need to.
We offer holistic financial planning. We are also Certified College Planning Specialists (CCPS) and Education Loan Analysts (ELA). There are only 500 financial advisors in America with such credentials. We strive to save our clients tens-of-thousands of dollars on college education.
*Clear Path Financial Planning doesn’t offer tax services.