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3 Tax Mistakes Parents Make That End Up Costing Them

3 Tax Mistakes Parents Make That End Up Costing Them

What are the most common tax mistakes parents make that cost them money at tax time?

There’s more to being a parent at tax time than claiming another exemption on your return.

Tax professionals see some mistakes time and time again that can cause parents to pay more tax than they should have to.

Take a look at these common tax mistakes and make sure you’re not making them:

1. Not knowing who takes the tax benefits for a child

Some single parents assume that if their ex is taking the dependency exemption, the custodial parent can’t take the earned income credit (EIC) on the basis of that child.

This mistake can cause them to miss out on thousands of dollars per year of potential EIC, even in excess of tax they paid or had withheld from their paychecks.

The EIC is generally based on qualifying children you have living with you, regardless of which parent takes the dependency exemption.

It’s often debatable who takes the dependency exemption for a child in cases where the parents are divorced or separated, or where someone else is supporting the family, such as a grandparent.

You know that you can usually take an exemption for your dependent children under age 19 who live with you. But you should also go through the questions in IRS Publication 17 to see if you can claim foster children, step-children, and grandchildren you support.

If you have children under 24 and attending school, you may still be able to claim them. (They don’t seem to get any cheaper as they get older!)

The child generally must live with you over half of the year, but this rule is easier to meet than you think.

Temporary absences for school or medical reasons don’t count. If you are a noncustodial parent, special rules apply.

2. Ill-advised education savings plans

Saving for education is a worthy goal.

However, saving too much, in the wrong way, without regard to future ramifications, can do more harm than good.

For example:

• Don’t fund your child’s education fund at the expense of your own retirement fund.

You’ll miss the tax advantages of funding your retirement plan. Retirement planning is not optional. Do it first.

Don’t fund your child’s education fund at the expense of your own retirement fund (tweet this!)

• Be careful investing in Section 529 college savings plans. These plans offer federal and state income tax advantages.

However, they’re not the best answer for everyone. In fact, in recent years, some investment companies have been reprimanded for improperly recommending Section 529 plans that were not appropriate.

Fees vary, as do state laws regarding tax advantages. Do your homework!

• Don’t assume your financial situation will remain the same. For example, you may buy U.S. Savings bonds, assuming you can take them out in a few years for education purposes and not pay tax on the interest.

If your income level has risen past the phase-out levels, surprise! You’ll get to pay tax on those withdrawals for college tuition, after all.

3. Reporting a child’s income on your return

Never report your child’s wage income on your return.

It may seem like the easy way to deal with a small W-2 form, however children must report earned income on their own return if they are required to file.

You wouldn’t want to report W-2 wage income on your return anyway, because your marginal tax rate is almost certainly higher.

You may be able to report your child’s income from interest, dividends, and capital gain distributions on your return.

This saves you from having to file a separate return, and it may be a good idea in a few situations.

However, reporting the income on your return is likely to have more disadvantages, particularly because your adjusted gross income will be higher.

Your adjusted gross income affects many items on your return, including your ability to claim certain credits and other breaks.

To be sure whether you’re better off reporting your child’s income on your return or on his or her own, try it both ways in TaxACT and compare the results.

Do you talk to your kids about taxes?

Photo credit: Louish Pixel via photopin cc

About Sally Herigstad

Sally Herigstad is a certified public accountant and personal finance columnist and author of Help! I Can't Pay My Bills, Surviving a Financial Crisis (St. Martin's Griffin). She writes regularly at CreditCards.com, Bankrate.com, Interest.com, RedPlum, and MSN Money. She is an experienced speaker and a member of Toastmasters International. Follow Sally on Twitter.