The Complete Tax Planning Guide for Parents: Maximizing Deductions, Credits, and Savings
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At a glance:
- Tax planning is crucial for parents looking to maximize their tax savings.
- Tax credits can save you a lot of money and may give you a larger refund.
- Education savings accounts and retirement accounts for children offer valuable tax advantages.
- Paying your child and spreading large gifts over multiple years can be good strategies depending on your situation.
Children change everything — including your taxes.
Balancing your duties as a parent can quickly become overwhelming, and it’s no wonder tax planning often falls by the wayside. But if you wait until tax time to start thinking about tax filing, you could miss out on valuable opportunities to save money as a parent.
Let’s take a look at some key factors that impact parents when filing taxes, including tax credits for dependents, education savings plans, and even retirement plans for children to help you make informed decisions for your family’s financial well-being.
Filing status matters
When you become a parent, your tax filing status becomes an important consideration. The filing status you choose can significantly affect your tax liability and potential tax benefits. Here are some of your options:
- Head of Household: If you are not married but pay more than half the cost of maintaining a household where your child lives, you can file as head of household (as opposed to just filing as single). Head-of-household status offers valuable tax advantages, including a higher standard deduction and potentially placing you in a lower tax bracket. Even if the child’s other parent claims them as a dependent, you can still use the head of household filing status.
- Married Filing Jointly: Filing jointly is also a common option if you’re married. This status lets you and your spouse combine your income and deductions on one tax return. Married filing jointly can provide various tax benefits, including potential access to higher income thresholds for certain tax credits and tax deductions.
- Married Filing Separately: Just because you’re married doesn’t mean you must file jointly with your spouse. Sometimes filing separately can be more advantageous depending on your tax situation, but other times it could mean missing out on certain tax deductions.
We review the advantages and disadvantages of filing jointly versus separately in I’m Married, What Filing Status Should I Choose?. Choosing the right filing status is essential, as it lays the foundation for the rest of your tax planning strategies.
What can parents write off on taxes?
As a parent, you may qualify for several tax credits designed to ease the financial burden of raising children. These credits can directly reduce your tax liability and potentially result in a larger tax refund. Here are some common tax credits for parents:
Child Tax Credit
Whether you have a baby in January or at the end of the year in December, you can claim the partially refundable Child Tax Credit for that tax year. The 2023 Child Tax Credit is worth $2,000 per qualifying child. You can claim it every year until your dependent turns 17.
A few things to note:
- The CTC phases out at higher income levels. You may be eligible for a lower credit if your modified adjusted gross income (MAGI) is $400,000 or higher as a joint filer (or $200,000 for all other filers).
- The refundable portion of the credit for tax year 2023 is $1,600 (up from $1,500 in 2022). That means if your tax bill is $0, you can receive up to $1,600 of the credit as part of your refund.
Non-Child Dependent Credit
The Non-Child Dependent Credit allows tax filers to claim a $500 credit for all dependents who are not qualifying children under the age of 17. That includes spouses, parents, and any dependents who are full-time students or disabled. The dependent must still pass all IRS dependency tests.
Child and Dependent Care Credit
If you pay for childcare expenses while you work or search for employment, you may be eligible for the Child and Dependent Care Credit. You can claim up to $3,000 of care expenses for one child or up to $6,000 for two or more children. The credit can cover up to 35 percent of qualifying care expenses.
Some qualifying expenses may include:
- Childcare provided by daycare centers or babysitters
- Day camp costs (overnight camps don’t qualify)
- Payments made to a cook or house cleaner (who also provided care for your dependent)
- Before- and after-school care for children under 13 years old
Many adoption costs can be offset by using the federal Adoption Tax Credit. For tax year 2023, that credit is worth up to $15,950 per child (up from $14,890 in 2022). 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 following year.
For example, let’s say your tax bill for 2023 is $5,000. If you claim the adoption credit worth $15,950 on your tax return, you have $10,950 to carry over to 2023. You can carry over the unused portion for up to five years.
The credit is based on your modified adjusted gross income and starts to phase out for families with a MAGI above $239,230 for 2023. You no longer qualify for the credit if your income exceeds $279,230.
Earned Income Tax Credit
Designed to assist low-income working taxpayers, the Earned Income Tax Credit (EITC) can significantly reduce your tax burden as a parent. The maximum credit available for 2023 is $7,430 for tax filers with three or more qualifying children (up from $6,935 in 2022). Income limits apply, with the maximum eligible income set at $63,398 for joint filers and $56,838 for single or head-of-household filers.
Understanding and leveraging these tax credits can lead to savings for your family.
Higher education savings plans
As a parent, planning for your child’s higher education expenses early on is crucial. Higher education savings plans, such as 529 plans and Coverdell Education Savings Accounts (ESAs), offer valuable tax advantages. Let’s take a closer look at these options:
There are two types of 529 plans: prepaid tuition plans and education savings plans. Prepaid tuition plans allow you to purchase “credits” at participating institutions to cover a child’s future tuition and mandatory fees. Credits are purchased at the institution’s current prices.
On the other hand, education savings plans are state-sponsored investment accounts that can be used for various education expenses. Contributions to 529 plans may be tax-deductible in some states, and earnings grow tax-free as long as the funds are used for qualified education expenses. Non-qualified withdrawals may be subject to income tax and a 10 percent federal tax penalty on earnings.
Coverdell Education Savings Accounts
Coverdell Education Savings Accounts (ESAs) are another way to save for college. These plans are similar to 529 plans but offer additional benefits. You open an ESA in the child’s name. Using this plan, you can contribute up to $2,000 annually. The main advantage 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 funds 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.
Opening a Roth IRA for your kids
Retirement planning for children may seem unconventional, but it can be an excellent strategy to give them a head start on their financial future. 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. Roth IRAs for kids offer tax advantages and allow them to take control of the account once they become adults.
Any adult can open a Roth IRA in a child’s name, provided the child has earned income during the tax year. For instance, if your 15-year-old child has a summer job, you can open a Roth IRA for them as long as they received at least one paycheck.
You can contribute the lesser of the child’s earned income for the year or the annual Roth IRA limit, which is $6,500 in 2023 (up from $6,000 in 2022). Contributions to your child’s Roth IRA are considered gifts and count against the annual gift tax exclusion limit ($17,000 for 2023). Roth IRAs grow tax-free, and qualified retirement withdrawals are tax-free.
Starting a Roth IRA early allows compounding to work its magic, potentially creating a substantial nest egg for your child’s retirement.
Other considerations for parents
Aside from tax credits and savings plans, there are several other tax planning strategies that parents should consider. Here are some additional tips to maximize your tax benefits:
Pay your child
If you have a business, one way you can legitimately reduce your tax bill is to pay your kids to work in the business.
This not only lets your kids learn the value of work and earning money, but they generally pay less tax on their income than you would because they are presumably in a much lower income tax bracket.
If you employ your child in your unincorporated business, you don’t have to pay or withhold FICA tax (Social Security and Medicare) for your child if the child is under the age of 18. If you pay your child for domestic work (household chores), you don’t have to pay or withhold FICA tax if they are under the age of 21. You don’t have to pay FUTA, federal unemployment tax, in either case, if your child is under age 21.
You don’t have to worry about the “kiddie tax” when you pay your kids to work. The kiddie tax only applies to investment income and unearned income and does not apply to earned income.
You can generally deduct payments made to your kids to work in your business, but you need to make sure that your kids can actually do the work they are being paid for and that the amount you pay them is reasonable.
Donate unused or outgrown items to charity
If you have kids, you probably have a constant supply of outgrown clothing and forgotten toys. Get a fresh start — and a great tax deduction — by hauling your unused items to a charitable thrift shop. Don’t forget to ask for a receipt and make notes about what you donated.
If you donate something worth more than $250, you’ll need a statement from the charitable organization describing the item (but not a valuation) and whether you received anything in value in return for the contribution.
TaxAct Donation Assistant can help you calculate your deduction for non-cash donations.
If you’re making cash contributions to your favorite charities, including organizations your children may be involved in, consider stepping it up at the end of the year. You’re going to contribute anyway, so why not write a check or put a contribution on your credit card by Dec. 31? This allows you to write off your donation for that year on your upcoming tax return instead of waiting for the following year.
Spread large gifts over multiple years
If you want to give a significant gift to your child (more than $17,000 in 2023), consider spreading the gift out over two or more years to avoid having to file a gift tax return.
For example, say you want to give your child $20,000 to use as a down payment on a house. If you give it to them all at once, you must file a gift tax return, and the extra $3,000 will count toward your lifetime exclusion limit. However, if you give them $10,000 in December and another $10,000 in January, you’re below the limit for both years.
Determine which parent can claim the kids
In the event of divorce, the IRS allows the custodial parent to claim the Child Tax Credit on their income tax return.
But what if you have joint custody? In that case, you have a couple of options. If you have one child with joint custody, you can alternate who gets to claim the CTC — if you claimed the child in 2022, the other parent would claim the child in 2023. If you split custody between two children, you could each claim one of them on your tax return.
And remember, if you provide a home for at least one dependent for more than half the year, you can file as a head of household instead of as single. You’ll generally pay less tax filing as head of household.
The bottom line
Being a parent comes with many responsibilities, including tax planning. By understanding the tax implications and leveraging available tax credits and savings plans, you can optimize your tax situation and provide a better financial future for your family. Remember to consider all the available options, seek professional advice when needed, and plan ahead to ensure your tax strategy aligns with your family’s goals.