We all know the cost of raising a child is significantly higher than any tax benefit you may receive. Every dollar you save on taxes counts, especially when you have more than one child. Whether it’s through tax deductions, exemptions or special tax-advantaged accounts, taking the necessary steps can help reduce the cost of raising a child.
On a 2016 tax return, your spouse, any dependents and you receive a personal exemption that reduces your taxable income by $4,050 each. Let’s say you’re in the 28% marginal tax bracket and receive four exemptions for your spouse, two kids and you. This leads to a tax savings of $4,356 [($4,050 x 4 exemptions) x 28%]. When you start a family, make sure to adjust the tax withholding from your paychecks to include the correct number of exemptions. This reduces the tax withholding, thereby increasing your paycheck to account for the additional exemptions.
Child tax credits
For each dependent under age 17, you may be eligible to receive up to a $1,000 tax credit for each child. Credits are better than deductions and exemptions as they directly reduce the taxes you owe versus reducing your income that’s subject to tax. The credit amount starts to get phased out at income levels of $110,000 on a joint return, $75,000 for an unmarried individual and $55,000 for married filing separately. The credit is reduced by $50 for each $1,000 your household income exceeds these income levels, so it’s completely phased out at $130,000, $95,000 and $75,000, respectively. This credit is also partially refundable, meaning that in some cases, the credit may give you a refund, even if you do not owe any tax. This is also known as the additional child tax credit.
Consider a married couple with two children under age 10 and a household income of $108,000. This puts them near the start of the 25% marginal tax bracket after subtracting the standard deduction and exemptions. So the $1,000 credit for each child in the 25% marginal tax bracket provides for $8,000 ($2,000 / 25%) of income not to be taxed. Another way of looking at it is that this couple would owe $2,000 more in taxes if their dependents were age 17.
Dependent Care Flexible Spending Account (FSA)
The $5,000 that can be contributed to this special account is not subject to payroll taxes, federal taxes and most state taxes. It’s a reimbursement account for qualified childcare expenses for dependents up until age 13. This FSA can be used to pay for daycare, nanny services, summer day camps and many more. Make sure to spend the money in the account by year end as it’s a use it or lose it situation, where any leftover balance is forfeited. However, your plan may offer a grace period extension that could allow you to use the unused funds within 2 months and 15 days after the plan year ends. Unfortunately, dependent care FSAs are only available through employer benefits plans.
To illustrate the tax savings, consider a couple living in California with taxable income of $250,000. Their marginal tax rate is 33% to federal, 9.3% to California and 7.45% to payroll taxes (Social Security and Medicare), leading to an overall marginal tax rate of 49.75%. The $5,000 contributed to a dependent care FSA effectively saves you $2,488 on taxes for expenses you would be paying normally with after-tax dollars.
Child and dependent care tax credit
If your employer doesn’t offer a dependent care FSA, or you have more than one child, you may still be able to qualify for a tax credit to cover part of the costs for daycare. The maximum amount of expenses you’re allowed to claim is $3,000 for one child or $6,000 for two or more children. You can use 20% to 35% of these expenses to get a tax credit, depending on your income. If your income is $43,000 or more, then you can use 20% of these expenses. There’s no limit on income for claiming this credit.
Consider if you have two children and an income of $75,000, and your childcare costs are $16,000 total. The first $6,000 of these costs is eligible for this tax credit, directly reducing your taxes owed by $1,200 ($6,000 x 20%).
You can’t claim the same child and dependent care expenses for both the credit and dependent care FSA mentioned above. In the event that you have two children and your costs are above $5,000, then you can use the FSA to get the greatest savings for the first $5,000, and then receive the 20% child and dependent care tax credit on the remaining $1,000 of expenses.
Earned income tax credit
The earned income tax credit (EITC) is a benefit for workers with low to moderate income. The EITC reduces the amount of tax you owe, and may give you a refund. For a person or couple to claim one or more persons as their qualifying child, requirements such as relationship, age and shared residency must be met. The amount of the credit depends on your income and number of children. To qualify, your investment income cannot exceed $3,400 a year and certain earned income limitations apply.
The table below provided by the IRS shows the income limitations for claiming this credit.
Qualifying Children Claimed
Three or more
|Single, Head of Household or Widowed||
|Married Filing Jointly||
The maximum amount of credit you can get for 2016 is:
- $6,269 with three or more qualifying children.
- $5,572 with two qualifying children.
- $3,373 with one qualifying child.
- $506 with no qualifying children.
The EITC is also a refundable tax credit, meaning you may receive a refund for more than the amount of taxes you already withheld or paid the IRS during the year.
Tax credits and deductions for dependents’ higher education costs
Even though college for your kids may be far in the future, be aware of deductions and tax credits available for costs you incur helping your dependents through school. There are two tax credits available – the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit – and one deduction called the tuition and fees deduction. You can’t claim more than one of these credits or deductions in the same year. Also, when you pay the tuition bill, make sure you haven’t already used all of the allowable expenses for that particular year. Paying the tuition bill for the spring semester in January instead of December allows you to put the expenses into another year where you may qualify for the credits or deductions.
American Opportunity Tax Credit – This tax credit is for the first four years of undergraduate studies and can lower your tax bill by up to $2,500, as long as you paid at least that much last year toward their education. The AOTC is a partially refundable tax credit, which means you may be able to receive a refund greater than the amount of taxes you paid during the year. The credit lets you claim all of the first $2,000 you spent on your child’s tuition, books, equipment and school fees, plus 25% of the next $2,000, for a total of $2,500. To claim this credit, your child must be listed as a dependent on your tax return.
You can receive the full credit if your income is less than $80,000 if single or $160,000 if married filing jointly. You can receive a partial credit if your income is between $80,000 and $90,000 if single, and $160,000 and $180,000 for married filing jointly. If your income is above these levels, then you can’t claim the credit.
Lifetime Learning Credit – This education tax credit is usually more appropriate for children in graduate school. This credit only applies to tuition and fees, and doesn’t include living expenses or transportation costs. You can claim 20% of the first $10,000 paid toward tuition and fees, for a maximum tax credit of $2,000. You can claim the full credit if you earned less than $55,000 if single and $110,000 if married filing jointly. You’ll receive a reduced tax credit if your income is between $55,000 and $65,000 if single, and $110,000 and $130,000 if married filing jointly. If your income is above these levels, you don’t qualify for the credit.
Tuition and fees deduction – Tax credits are usually superior to tax deductions because they reduce the taxes you owe directly, but in some cases you may choose to claim the tuition and fees deduction instead. This deduction can be used to reduce your taxable income by up to $4,000.
The full deduction is available to those who earned less than $65,000 if single and $130,000 if married filing jointly. The maximum deduction is $2,000 if you earned between $65,000 and $80,000 if single, and $130,000 and $160,000 if married filing jointly. The deduction is not available if you earned more than this.
You can use this deduction in two cases. The first is when your income is above the $130,000 married-filing jointly phase-out for the Lifetime Learning Credit. The second is when you have closer to $4,000 in qualified expenses and your marginal tax bracket (the tax rate you pay for each additional dollar of income) is 25%. Using the deduction in this case, instead of the Lifetime Learning Credit, provides a greater ta
x benefit because you receive $1,000 ($4,000 x 25%) versus the Lifetime Learning Credit $800 ($4,000 x 20%).
Using a handful of these tax benefits while you’re raising your children may give you just the relief you need in your budget so you have more funds available to do the things that matter most to your family.
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Geoff has always enjoyed talking with people about finance, learning about their investments, financial strategy, and business sense. His interest only deepened with time, and what began as a hobby has now become a life-long passion, with an unparalleled passion for continuing education that makes him an expert in many subjects from traditional taxes and investments to business succession planning and executive compensation negotiations.
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