According to the U.S. Department of Agriculture, in a study conducted in 2013 (the most recent year the study was conducted), it cost a middle-income family $245,340 to raise a child up to age 18. When your clients announce the happy news they are expecting, this is probably not the news they were expecting to hear from you. It may be better to stick with explaining to them the tax adventure, which begins before clients have children and continues until the kids turn 27 years old.
It all begins with an adoption credit, and may not end until they buy their own insurance when they reach the age of 27. The tax-saving options to consider are extra exemptions, child tax credits, earned income tax credits, dependent care credits and a significant adoption credit.
Exemptions. Each child creates an exemption from income to be taxed. Each personal tax exemption is $4,050 in 2016, up from $4,000 in 2015. This dependent exemption can be taken every year until the child turns 19. Actual tax savings rise with adjusted gross income (AGI), until it begins to phase out at $311,300 for married couples filing jointly for 2016.
Child Tax Credit. Clients with children under 17 years old may receive a full $1,000 tax credit per child, as long as income is below $110,000 for married couples filing jointly. The child tax credit is in addition to any child, dependent care credit and dependency exemptions for which your client qualifies. The credit begins to be reduced when clients’ modified AGI exceeds $110,000, if filing jointly. For every $1,000 of income above the threshold, the available child tax credit is reduced by $50. If the child tax credit exceeds your clients’ tax liability, their tax bill is reduced to zero. Any unused credit is lost, unless the client is eligible to claim a refundable Additional Child Tax Credit for the unused balance. They could receive up to 15 percent of their total earned income over $11,750, and under the limitation of $110,000 for married filers. Beginning in 2015, if a client files Form 2555 or 2555-EZ (both relating to foreign earned income), they cannot claim the Additional Child Tax Credit.
Earned Income Tax Credit. The maximum Earned Income Credit amount is $6,269 for taxpayers filing jointly who have three or more qualifying children in 2016, up from $6,242 for 2015. Earned income and AGI may not exceed $53,267 for clients with three or more children. As a paid preparer filing an EITC claim for a client, you are required to ask due diligence questions and submit Form 8867. The penalty for filing any earned income tax credit claim when missing the Form 8867 is $505 per return for 2015.
Dependent Care Credit. Payments made to care for a child under age 13, or other qualifying dependent, while the client works can also earn a tax credit. The total qualifying expenses may not exceed $3,000 for one qualifying individual, up to a maximum of $6,000 for two or more. If a client does not work but goes to school full-time, an annual earned income of $3,000 is used to apply this credit. Amounts paid for the cost of kindergarten or specialty day camps are eligible for the dependent care credit. Computer camps, or soccer camps, are eligible for dependent care credit, even though some education is provided. None of the cost of an overnight camp qualifies.
If an employer pays these costs for your client, the first $5,000 of this benefit can be excluded from income. Any additional amount the employer pays must be reported as income. Flexible spending accounts (FSAs) offered by an employer can pay child-related expenses with pre-tax dollars. FSA dollars avoid federal income, Social Security and Medicare taxes, and, in almost all states, state income taxes.
Adoption Tax Credit. A client qualifies for the adoption tax credit if they incur out-of-pocket expenses when adopting a child under 18 years old, or a child of any age who is physically or mentally disabled. For 2016, the maximum credit is $13,460 per child. The credit applies to all reasonable and necessary adoption expenses, including court costs, attorney fees and traveling expenses. If a client’s modified adjusted gross income (MAGI) is over $201,920, the adoption credit begins to phase out for taxpayers up to MAGI of $241,920, when it completely phases out.
Through the Affordable Care Act, the tax adventure of having children was extended until a child reaches age 27 because parents may provide insurance to children up to that age. While there are incidental tax considerations for having children, such as buying a larger home or education tax incentives, the direct effects are the exemptions, child care, dependent care and earned income credits.
Editor’s note: This is the third article in a series of articles about life changes and tax. Be sure to read the rest of the series!