Children change everything. And that’s especially true when it comes to your tax planning.
Whether you’re a new parent or you’ve raised kids for years, it’s important to understand the tax implications so you can plan ahead.
To get started, follow this tax planning guide for parents.
Your filing status matters
When you were single and living life independent of anyone else, you used the Single filing status to file your return. But now that you have a kid(s), things are different. Filing as Single no longer works. And depending on your marital status, you have a few different options to choose from.
For example, if you’re not married but pay more than half the cost of maintaining a household where your child lives, you can file as Head of Household. Switching your filing status from Single to Head of Household comes with important tax advantages. You’ll likely enjoy a lower tax rate and a higher standard deduction. You can even use the Head of Household filing status even if the child’s other parent claims them as a dependent.
If you’re married, you probably already elected to file a joint return. In that case, there’s no need to make any changes.
Tax reform changed the dependency exemption
Prior to 2018, parents could claim a personal exemption on their return for every dependent – aka qualifying child. The dependency exemption reduced your taxable income, which ultimately impacted how much tax you owed each year. In 2017, the exemption was worth $4,050.
But when tax reform signed into law back in Dec. of 2017, all that changed. The dependency exemption essentially went away. It dropped to $0, making it meaningless to filers.
While that initially sounds like a disadvantage, the good news is other changes in the tax code make up the difference for many people. For example, the standard deduction nearly doubled for most filing statuses. And several credits dedicated to children and dependent care increased in value.
The Child Tax Credit increased
Whether you have a baby in January or at the end of the year in December, you can claim the Child Tax Credit for that tax year. Beginning Jan. 2018, the Child Tax Credit increased from $1,000 to $2,000. You can claim it every year until your dependent son or daughter turns 17.
A few things to note:
- The credit phases out at higher income levels. If your adjusted gross income (AGI) is $75,000 or higher ($110,000 if filing jointly), you are eligible for a lower credit amount.
- The refundable portion of the credit increased to $1,400. That means if your tax bill is $0, you can receive up to $1,400 of the credit as part of your refund.
- Income limits are in place for the credit. However, the AGI amounts increased allowing more individuals to take advantage of it. The 2018 phaseout starts at $200,000 for single tax filers and $400,000 for joint filers.
- Tax filers who earn $2,500 or more per year can claim the credit.
A new credit was introduced
Tax reform introduced a new element to the dependent credit for 2018 called the Non-Child Dependent Credit. It allows tax filers to claim a $500 credit for all dependents who are not qualifying children under the age of 17. That includes spouses and any dependents who are full-time students or disabled. The dependent must still pass all dependency tests.
Tax advantages for child care costs exist
If you pay someone to take care of your child while you work or look for work, you may qualify for the Child and Dependent Care Credit. You can claim up to $3,000 of care expenses for one child. If you have two or more, you can claim up to $6,000.
There is no income phase-out, however, the credit can only equal up to 35 percent of your qualifying care expenses.
Benefits are available for adoption costs
The adoption credit is quite amazing.
Many adoption costs can be offset by using the Federal Adoption Tax Credit. In 2018, that credit is worth up to $13,840 per child. It is nonrefundable, which means if your tax bill is $0, you won’t receive any portion of the money back as a refund. You can, however, carry forward any unused portion of the credit to the next year. For example, let’s say your tax bill for 2018 is $5,000. If you claim the adoption credit worth $13,840 on your tax return, you have $8,840 to carry over to 2019. You can carry over the unused portion for up to five years.
The credit is based on your modified adjusted gross income (MAGI) and starts to phase out for families with a MAGI above $207,580. If your income is above $247,580, you no longer qualify for the credit.
Think about the Earned Income Credit
The Earned Income Tax Credit, or EITC, is designed to help working parents at low-income levels. As a credit, it directly reduces the amount of tax you owe.
For 2018, the maximum value of the credit available is $6,431. That’s available to tax filers who have three or more qualifying children. To claim it, you must earn less than $54,884 as joint filers or $49,194 as a Single or Head of Household filer.
Higher education savings plans offer tax benefits
The sooner you start thinking about the cost of higher education, the easier it is to save.
To start, look into 529 plans. There are two different types and both are tax-advantaged.
Prepaid tuition plans allow parents to purchase “credits” at participating institutions to cover the costs of their child’s future tuition and mandatory fees. Credits are purchased at the institution’s current prices.
Education savings plans are investment accounts opened for a child to cover all costs associated with higher education. Those funds can be used at most institutions. They are not limited to one particular place. Educations savings plans can also be opened to cover the costs of tuition at any public, private, or religious elementary or secondary school.
The tax advantages available through both plans vary by state. Many states allow you to deduct contributions on your state tax returns.
Across the board, earnings within 529 plans are not subject to federal income tax. Many states also do not collect income tax on those dollars. The same goes for withdrawals. As long as they are used for higher education expenses, they are tax-free. In the event they are not, you will have to pay federal and state income tax along with a 10 percent federal tax penalty on the earnings.
Coverdell Education Savings Accounts (ESA) are another way to save for college. An ESA is opened in a child’s name. They are similar to 529 plans but offer additional benefits. If you use this plan, you can contribute up to $2,000 annually. The main benefit over a 529 plan is that funds from these accounts can be used to cover qualifying costs above and beyond tuition to attend elementary or secondary schools. While 529 plans only cover the cost of tuition, ESA money can be used to pay for books, supplies, equipment, etc.
The good news is that you can open multiple accounts for your children. When it comes time to pay education expenses, you can withdraw money from a 529 to cover tuition and money from an ESA to cover all other expenses. Both accounts have limitations on withdrawal amounts.
Consider opening a Roth IRA for your kids
Retirement planning for youngsters? It’s not a crazy thought.
If you look at how well modest investments fare over the years, you can easily see the benefit of starting a savings fund as soon as possible. A number of brokerages offer Roth IRAs for kids and any adult can open one in the child’s name. When the child becomes an adult, he or she takes control of the account. Your child simply needs to have earned income in the tax year to qualify.
For example, let’s say your son is 15 and has a summer job working at the local pool. As long as he earned at least one paycheck that summer, you can open a Roth IRA in his name. You can also contribute up to the annual Roth IRA limit, which is $5,500 in 2018. Keep in mind, you must provide documentation that he had earned income. And it can’t be an allowance or a gift.
The contribution you make to your kid’s account is considered a gift, and he or she does not have to pay tax on it. The amount will count against your annual limit on tax-free gifts, which is $15,000 per person in 2018.