Cash In on Kids at Tax Time

They may tax your patience, but be sure to take advantage of the credits and deductions that apply to them.
By Tracy Byrnes ,

There are moments in a parent's life when you question why you had children in the firstplace. 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 awrite-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. Aslong as your adjusted gross income doesn't exceed $107,025, you'll get a $3,100 exemption for eachchild (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 creditis $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 tophase out by $50 until it hits zero. The phase-out begins at $75,000 if you file as singleor 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 canwork or go to school, you may also qualify for the child and dependent care credit. So tally upthose daycare or after-school care costs. You can include up to $3,000 of the expenses paid in ayear 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 from20% to 35% of your qualifying expenses will count, depending upon your AGI. So the minimum credityou'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 agewho 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, thosecosts 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 monthlyjournal 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 ascollege or vocational school, and can be worth up to $1,500 per eligible student, per year. Itdoesn't apply to graduate and professional-level programs. You're allowed 100% of the first $1,000of qualified tuition and related fees paid during the tax year, plus 50% of the next $1,000. Eachstudent must be enrolled at least part-time.

The Lifetime Learning Credit applies to undergraduate, graduate and professional degreecourses, including courses you take to get a job or improve your job skills. If you qualify, yourcredit equals 20% of the first $10,000 of the tuition and fees you pay during the year. It maxesout 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 forsingles).

Big note: According to the IRS Web site, "the Hope Credit is not allowed for a studentconvicted of a felony drug offense." No mention of the Lifetime Learning Credit, though. (I swearI 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 acouple 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%. Anythingafter 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 onlybe subject to the 10% income tax bracket. To capitalize on this rate, consider selling someshort-term securities in your child's name. Then your child, a.k.a. you, will only owe 10% tax onthe 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 researchspecialist at H&R Block. "Kids are subject to AMT laws at lower amounts than we are." For kidsunder 14, income in excess of $5,750 could be subject to AMT, says Gutierrez. Most adults don't haveAMT issues until they hit at least $40,000. So run the numbers before you have Junior sell someof your holdings.

Other Provisions

If you're a single parent, consider filing under head of household instead of single status. Aslong 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 forqualifying expenses paid to adopt an eligible child (including a child with special needs), saysGutierrez. The credit generally is allowed for the year following the year in which the expenseswere incurred.

And while I know you'd do anything for your child, please consider this next option yourlast resort: If you take funds out of your IRA to pay for your kid's college tuition, you willnot have to pay the 10% early distribution fee that would be charged on other distributions takenbefore 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, youcould 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 thewithdrawal.

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

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

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University.

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