Investor Forum

Return to Article

Cash In on Kids at Tax Time

Tracy Byrnes

There are moments in a parent's life when you question why you had children in the first place. I know, I have three of them.

But as taxing as they may be, when tax season comes around, you realize that, if nothing else, your little darlings are a write-off.

Thankfully, you get money back from Uncle Sam for all your hard work and undying love.

Get Credit for Raising Your Kids

Right off the bat, you get additional exemptions for each dependent child. As long as your adjusted gross income doesn't exceed $107,025, you'll get a $3,100 exemption for each child (yourself and your spouse, too!). And if you had a newborn in 2004, take one for that baby, too. The exemptions will phase out, or decrease, as AGI climbs above $107,025.

Next, you may be eligible for the child tax credit. For 2004, the maximum amount of the credit is $1,000 for each dependent child under age 17.

Once your AGI hits $110,000 as a married couple filing jointly, the $1,000 credit starts to phase out by $50 until it hits zero. The phase-out begins at $75,000 if you file as single or head of household, which we'll get to in a minute.

If you have kids under age 13 and you pay someone to watch them so you and your spouse can work or go to school, you may also qualify for the child and dependent care credit. So tally up those daycare or after-school care costs. You can include up to $3,000 of the expenses paid in a year for one child, or up to $6,000 for two or more kids.

To calculate this credit, you must apply a percentage to that expense number. Anywhere from 20% to 35% of your qualifying expenses will count, depending upon your AGI. So the minimum credit you'll get is $1,200 (20% of $6,000), while the maximum is $2,100 if you have two kids.

The credit may also be used if you paid someone to care for a spouse or a dependent of any age who is physically or mentally incapable of self-care. The same limitations apply.

Big note: If you send your kids to a summer day camp so you and your spouse can work, those costs may be included as part of your qualifying expenses. Sleep-away camp, however, does not count, says Bob Scharin, editor of Warren, Gorham & Lamont/RIA's Practical Tax Strategies, a monthly journal written for tax professionals, because it is considered more of a luxury than a necessity.

Check out the IRS' Publication 503 - Child and Dependent Care Expenses for more details.

If your baby is in college, check out the education credits.

The Hope Credit applies only to the first two years of post-secondary education, such as college or vocational school, and can be worth up to $1,500 per eligible student, per year. It doesn't apply to graduate and professional-level programs. You're allowed 100% of the first $1,000 of qualified tuition and related fees paid during the tax year, plus 50% of the next $1,000. Each student must be enrolled at least part-time.

The Lifetime Learning Credit applies to undergraduate, graduate and professional degree courses, including courses you take to get a job or improve your job skills. If you qualify, your credit equals 20% of the first $10,000 of the tuition and fees you pay during the year. It maxes out at $2,000 per tax return.

You cannot claim both for the same student in the same year.

These credits are phased out when your AGI hits $83,000 and you are filing a joint return ($41,000 for singles) and eliminated completely for $103,000 and over ($51,000 for singles).

Big note: According to the IRS Web site, "the Hope Credit is not allowed for a student convicted of a felony drug offense." No mention of the Lifetime Learning Credit, though. (I swear I didn't make that up.)

IRS Publication 907 - Tax Benefits for Education has more grist.

Capitalize on Your Children

If your children already have income, good for them.

The rules are hairy but in a nutshell, the first $800 is a freebie. So if your kid has a couple hundred in interest and dividends, you don't even have to bother reporting it.

The next $800 is taxed at the child's rate, or the lowest tax bracket rate, of 10%. Anything after that is taxed at the parent's rate until your child hits 14.

Then your kid is taxed on his own. Presuming he doesn't have a lot of income, he'll still only be subject to the 10% income tax bracket. To capitalize on this rate, consider selling some short-term securities in your child's name. Then your child, a.k.a. you, will only owe 10% tax on the income vs. what could be as high as 35% on your federal return if you sold them in your name.

Just be aware of alternative minimum tax issues, warns Mary Gutierrez, a tax research specialist at H&R Block. "Kids are subject to AMT laws at lower amounts than we are." For kids under 14, income in excess of $5,750 could be subject to AMT, says Gutierrez. Most adults don't have AMT issues until they hit at least $40,000. So run the numbers before you have Junior sell some of your holdings.

Other Provisions

If you're a single parent, consider filing under head of household instead of single status. As long as you provide the household where your child lives, you can qualify for lower tax rates.

If you adopted a child recently, you may be able to take a tax credit of up to $10,390 for qualifying expenses paid to adopt an eligible child (including a child with special needs), says Gutierrez. The credit generally is allowed for the year following the year in which the expenses were incurred.

And while I know you'd do anything for your child, please consider this next option your last resort: If you take funds out of your IRA to pay for your kid's college tuition, you will not have to pay the 10% early distribution fee that would be charged on other distributions taken before age 59. Of course, you would owe income tax on the money.

In addition, if you want to help your child and spouse buy their first home, you could again take the funds out of your IRA and qualify for the first-time home buyer withdrawal. That means you would not owe the 10% penalty again, but you would owe the income tax on the withdrawal.

But while you love your children and want to help them, please make sure you're covered in retirement before you pull money from your IRA.

So take advantage of your little sweeties while you still can. Soon enough they'll be out on their own and that's one deduction you'll certainly miss.