Having your first child means more chores–more laundry, more shopping, more food preparation and yep, more tax planning and paperwork too.
So you’d think the politicians would want to simplify life for time-pressed parents. Instead, in an effort to show they’re family friendly, they’ve created numerous, sometimes overlapping tax breaks for children, for child care and for education. Then, to hold down the tax cost of all those tax goodies, they’ve added various phaseouts and gotchas, which interfere with some families’ ability to claim them. Still, at the right income level and with a little planning, your bundle of joy could turn into a bundle of tax savings.
First consideration: timing. If you had your baby after Jan. 1, you can’t claim a penny of the two basic child breaks–the dependent exemption, which knocks $3,650 off your taxable income per child or the child credit, which cuts your tax bill by $1,000 per child–on your 2009 return due April 15. If your child was born Dec. 31, congratulations; you can get the full year break for 2009. “Having a baby in December, that’s what I call good tax planning,” quips Robert Meighan, a CPA and vice president of Turbo Tax, Intuit‘s ( INTU – news – people ) tax preparation software unit.
(If you’re not expecting until later in 2010, there might still be a way to cut your 2009 bill: High medical expenses associated with conceiving or with an ongoing pregnancy could be deductible for 2009. For more on medical deductions, click here. Also, if you’re in the process of adopting, save those 2009 receipts. They can be used to claim an adoption credit of up to $12,150 in the year your adoption is final.)
The dependent exemption is available for children who are 18 or under (or 23 and under, if they’re full-time students) for at least part of the year. The child credit is available for children who are 16 or younger for the full calendar year. You can get them both if your kids are the right age. Sound simple? For many middle-class families these breaks are in fact simple to claim–or simple compared with those for child care. Standard tax software such as TurboTax or H&R Block‘s ( HRB – news – people ) At Home will calculate them for you.We say for “many” families, because both low-income and upper-middle-class families face special complications. Congress has made the $1,000 child credit partially “refundable”–meaning lower-income families who don’t actually owe any income taxes can get a government check for part of the credit. Couples with income as high as $40,000 (with one child) or $48,000 (with three children) may also qualify for an Earned Income Tax Credit. For more on the EITC, click here.)
Note that taxpayers with AGI below $57,000 may be able to complete their federal returns and file online for free through the IRS’s FreeFile program.
Still, the complexity of all these credits, for even lower income folks, helps explain why 60% of taxpayers use preparers and Jackson Hewitt Tax Service ( JTX – news – people ) is this tax season setting up shop in 1800 Wal-Mart ( WMT – news – people ) stores.
What about those higher-income folks? Couples begin to lose the child credit when their modified adjusted gross income hits $110,000; single parents when it hits $75,000. In 2009, exemptions begin to phase out at $250,200 for couples filing jointly and $208,500 for single parents, but some families making far less lose the exemptions too because they’re stuck in the alternative minimum tax, which doesn’t allow personal exemptions at all. (For more on phaseouts, click here.)
If you’re near the child credit phaseout range, start thinking about ways to reduce your AGI, such as increasing your pre-tax contributions to a 401(k) and diverting pre-tax money into a dependent care account, rather than claiming the dependent care credit.
Now here’s where it gets really confusing. You can divert up to $5,000 per year from your pretax salary to pay for child care costs, including nursery school tuition, after-school programs, summer day camp and a nanny’s wages. To use a dependent care account (or to claim the dependent care credit) you must need child care to earn an income. So if you’re married, both spouses must be employed, unless one is disabled, a full-time student or looking for work. If both spouses work for employers who offer these accounts, the combined set aside can’t exceed $5,000.
Normally, you must make decisions about how much to put into a dependent care account before the start of the year, but you can change your election within 30 days of a change in your family status, such as the birth of a child.
Warning: You can’t recover unspent money from your pretax account or carry it over to the next year. So if you’re unsure how high your childcare bills will be–maybe you don’t know whether you’re both going back to work–put less in the dependent care account and make greater use of the dependent care credit. In fact, coordinating these two breaks is one of the biggest areas of tax confusion new parents confront.
You can claim the credit against a maximum of $6,000 of expenses, or $3,000 if you have only one child. The dependent care credit equals 35% of costs for the lowest-income families, but those with $43,000 of AGI or more get a 20% credit, saving at most $1,200. President Obama, as part of his new middle-class families initiative, wants to extend the 35% rate to families making up to $85,000, for a maximum tax credit of $2,100 for two or more children, and $1,050 for one. The 35% rate would be phased out as income climbed, and those earning more than $115,000 would be back to the old 20% rate.
Bottom line: Even if Congress adopts Obama’s proposal, if you’re high income, and particularly if you have only one child, you will still save more with the $5,000 dependent care account, provided you don’t set aside money you never use. Note that if you have two or more eligible children you can put $5,000 in the pretax account and then claim a 20% credit for an additional $1,000 in childcare bills–but not for the same expenses.
If you’re setting money aside for the first time in a pretax dependent care account, there’s one more gotcha, warns Susan Nash, an employee benefits lawyer at McDermott, Will & Emery. Your employer typically might cut off funding below $5,000 because of an IRS rule designed to make sure that low-income as well as high-income employees at a company use pre-tax accounts. Nash has had clients stuck with extra income on their W-2 that they didn’t count on at year-end because they thought they could shelter the full $5,000, and then found they couldn’t. “That tends to make highly paid people angry at year-end,” she says. For even more detail on child care breaks and the nanny tax, click here.