Most parents wouldn't trade the experience of raising children for anything in the world.
If only it weren't so darn expensive. Between the medical bills, child care and college tuition, it's a wonder parenting hasn't gone the way of the wet nurse. Fortunately, the government offers some generous tax breaks to help ease the financial burden. It's up to taxpayers, of course, to take full advantage of them — and in some cases this can be difficult, since it may involve figuring out which breaks are more beneficial than others.
There are a few things parents should understand. First, most child-related deductions and credits are available whether families take the standard deduction or itemize their taxes, says Martin Nissenbaum, national director of retirement planning and taxation with Ernst & Young. Second, there's a difference between deductions and the more coveted tax credits. Don't confuse the two. A deduction, such as the tuition and fees deduction, merely decreases taxable income. A tax credit, such as the child-tax credit, allows taxpayers to subtract the amount dollar for dollar from their tax bill, or add the amount to their refund.
The most generous tax breaks come with income limits. The tax credits in particular are geared more for middle- and lower-income families. If you don't qualify for a credit or deduction, you can still save money by setting aside pretax dollars in flexible-spending accounts for medical and child-care expenses. If your employer doesn't offer these, you may qualify for one of the new health-care spending accounts. While these can't compare with tax credits, they will help cover some essential parenting costs.
Here's a brief summary of the most common tax breaks available for parents. Some of the rules can be complicated, to say the least; when in doubt, consult a tax adviser.
DeductionsExemptions. Let's start with the basics. Every member of a household potentially counts toward a tax-deductible exemption on the family tax return. In 2007, each exemption is worth a $3,400 deduction. So a married couple with two kids qualifies for four exemptions, or a $13,600 tax deduction.
What many people don't realize is that even exemptions have income limits, warns Jackie Perlman, a senior tax research analyst with H&R Block. For 2007, the tax exemptions for married couples filing together start to phase out at adjusted gross incomes (AGI) of $234,600, $117,300 for married filing separately, and for heads of households, $195,500.
Tuition and fees. Helping a child pay for college? Uncle Sam will cut you some slack. In 2007, parents can deduct up to $4,000 in tuition expenses, provided their modified AGI doesn't exceed $130,000 for married couples or $65,000 for single parents. That deduction gets cut in half to $2,000 for married couples making between $130,001 and $160,000, and for single parents earning between $65,001 and $80,000. The deduction is wiped out entirely for those with higher modified AGIs. Parents should also note that the college tuition and fees deduction can't be used in conjunction with any other education credits, such as the Hope Scholarship or Lifetime Learning credits, which we will discuss later. Also, this tax break won't be around for 2007 and beyond unless Congress extends it (which is likely).
Student-loan interest. Even if parents set aside money for their child's college tuition, chances are they'll still need to borrow money. Thankfully, a portion of qualifying student-loan interest (loans from family, for example, don't count) is also tax deductible. The IRS allows parents to write off up to a maximum of $2,500 in loan interest. For 2007, this deduction phases out for married filers with modified AGIs between $110,001 and $140,000 and for single filers between $55,001 and $70,000. The only rule here is that students must be enrolled at least part time in a degree program to qualify. For more on student loans, see our story.
Tax CreditsChild-tax credit. In a parent's eye, a child is priceless. Uncle Sam puts the figure at $1,000, in the form of a tax credit. And unlike some other credits and deductions, the government doesn't limit how many children qualify. So if you have four little darlings under the age of 17, expect to get $4,000 swiped off your tax bill.
Like most credits, this one also has income restrictions, but they vary depending on how many children parents are claiming. The child-tax credit starts to phase out at modified AGIs that exceed $110,000 for married couples filing together, $55,000 for married filing separately and $75,000 for single parents.
Child and dependent care credit. Two-income households with children under 13 years old qualify for a dependent-care credit to help cover child-care expenses. The IRS allows working parents and those looking for a job (students and disabled parents also qualify) a credit of 20% to 35% on expenses up to $3,000 in child care for one kid and $6,000 for two or more kids. This translates into a maximum credit of $1,050 for one child and $2,100 for two or more kids.
The credit for parents earning more than $43,000 shrinks to just $600 for one child and $1,200 for two or more kids. Bernard Kent, a partner with PricewaterhouseCooper, recommends higher-income taxpayers set aside pretax dollars in an employer's flexible spending account instead. We'll talk more about these later.
Hope Scholarship credit. As we mentioned earlier, there are two education credits. The Hope Scholarship credit is for parents who are helping a child pay for college, and is worth up to $1,650 in 2007. To qualify, the young coed must be at least a part-time student in his or her first two years of secondary education. (This credit can be used only twice for each student, but there is no limit on the number of children who can qualify in any given year.) The income restrictions are a bit tighter than with the tuition and fees deduction. For 2007, this credit phases out for married filers with modified AGIs between $94,001 and $114,000, and $47,001 and $57,000 for single parents.
Lifetime Learning credit. The Lifetime Learning credit is far less restrictive than the Hope Scholarship credit. It covers students in their junior and senior years, and any other family members taking classes to improve their job skills. Here's the hitch: It can be claimed only once on any given tax return. Some families, however, will be able to claim the Hope Scholarship credit for one student and the Lifetime Learning credit for another. The latter is worth up to a 20% credit on tuition and other expenses of $10,000 or a maximum of $2,000. The income restrictions for the Lifetime Learning credit are the same as those for the Hope Scholarship credit.
Adoption credit. No one said adopting a child would be easy or inexpensive. There's the waiting game, the agency interviews and the lawyer fees. To help ease the process, in 2007 the IRS allows new parents an adoption credit worth up to $11,390. And if parents adopt a special-needs child, they can take the full credit even if their expenses totaled less than the value of the credit, says Ernst & Young's Nissenbaum. (In 2007, the credit starts to phase out when one's modified AGI exceeded $170,820.)
Cafeteria PlansMedical costs. Whenever possible, take advantage of an employer's cafeteria plan, also known as a flexible spending account, to help pay for medical expenses. These allow employees to use pretax dollars to cover all out-of-pocket medical costs not reimbursed by a health plan. There are no income limitations. Most employers, however, limit contributions to $4,000.
Child care. As we mentioned earlier, parents earning more than $43,000 are better off signing up for an employer's dependent-care spending account. Just like the medical accounts, these plans allow taxpayers to set aside pretax dollars for child-care expenses. The IRS limit is $5,000.
The only danger with flexible spending accounts is that any money that isn't used is lost. So budget accurately. And don't forget to save those child-care receipts. Your employer probably won't allow you to simply fill out a form stating that tuition at your local daycare center is $5,000.
DivorceFinally, you may have noticed that we haven't discussed ways divorced parents can divvy up all these tax deductions and credits. As a rule of thumb, the parent with custody for the greater part of the year gets to claim them. Of course, sometimes parents share custody, and this can get a little complicated. Whenever possible, try to work these things out early and have them noted in the divorce agreement, suggests H&R Block's Perlman. This will save everyone one less headache come April.
By Stacey L. Bradford
