Have Kids? IRS Says Take a Break
by William M. Cressman and Gregg Semanick
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This article was written by information specialists William M. Cressman of the IRS Pennsylvania Field Office and Gregg Semanick of the New Jersey Field Office, which also serves Delaware.
Taxpayers with children should consider claiming deductions, tax credits and benefits for which they might be eligible when completing their federal income tax returns.
Credits are dollar-for-dollar reductions in tax. Deductions reduce the amount of taxable income and generally result in an actual tax benefit equivalent to your tax bracket. For example, a $100 tax credit would lower your taxes by $100, whereas a $100 tax deduction would lower your taxes by $15 if you are in the 15 percent tax bracket.
The most basic deduction for parents is the tax exemption for dependents. There are five tests that establish whether a person, including your child, can be claimed as a dependent: relationship, citizenship, joint return, gross income and support.
In general, children age 18 and under readily meet the requirements and are dependents. Usually, children who are older than 18 and under age 24 can also qualify as dependents if they are students. The deduction for dependents is $3,100 per dependent.
TAX CREDITS
Some of the credits taxpayers with children could be eligible to claim are as follows.
Earned Income Tax Credit (EITC)
This is a refundable credit for low-income working individuals and families. Income and family size determine the amount of the EITC. Unlike most tax credits that can be used only to the extent that they reduce the total tax to zero, the “refundable” nature of this credit means that when the EITC for eligible individuals exceeds the amount of taxes owed, the remaining excess amount of credit is refunded.
Some taxpayers may be eligible to claim the EITC for the first time this year, especially if there were changes in the family such as a new child, divorce or decrease in earnings during the past year.
To qualify for the EITC, taxpayers must have earned income during the year. Married taxpayers who file a joint return may qualify if at least one spouse has earned income. For tax year 2004, earned income includes all taxable employee income, such as wages and tips, and net self-employment income.
To qualify for the credit, the taxpayer’s earned income and adjusted gross income must be less than: $34,458 ($35,458 if married filing jointly) with more than one qualifying child; $30,338 ($31,338 if married filing jointly) with one qualifying child; or $11,490 ($12,490 if married filing jointly) without a qualifying child.
To be a qualifying child, the child must meet age, relationship, and residency tests. To be eligible for this credit without a qualifying child, a taxpayer and spouse (if filing jointly) must be at least 25 years of age but under age 65, not be claimed as a dependent on someone else’s tax return and have made his or her home in the U.S. for more than half of 2004.
Only one taxpayer can claim the child for EITC purposes. Taxpayers who want to claim the EITC should make sure they are eligible for the credit before filing their tax return. For additional information see IRS Publication 596.
This publication and other publications and forms are available on the IRS website, www.irs.gov, under “Forms and Publications.” You may also order them by calling the IRS toll free at 800-TAX-FORM (800-829-3676).
Child Tax Credit
The maximum amount of the credit is $1,000 for each qualifying child.
With the Child Tax Credit, you may be able to reduce the federal income tax you owe by $1,000 for each qualifying child under the age of 17. A qualifying child for this credit is someone who is claimed as your dependent; is under age 17 at the end of 2004; is your son, daughter, adopted child, grandchild, stepchild or eligible foster child, your sibling, stepsibling or their descendant; and is a U.S. citizen or resident.
The credit is limited if your modified adjusted gross income is above a certain amount. The amount at which this phase-out begins varies, depending on your filing status: married filing jointly, $110,000; married filing separately, $55,000; and all others, $75,000.
This credit can be claimed in addition to the credit for child and dependent care expenses.
Child and Dependent Care Credit
If you paid someone to care for a child or a dependent so you could work, you may be able to reduce your tax by claiming the credit for child and dependent care expenses on your federal income tax return. This credit is available to people who, in order to work or to look for work, have to pay for child care services for dependents under age 13. The credit is also available if you paid for care of a dependent of any age who is physically or mentally incapable of self-care.
The credit is a percentage, based on your adjusted gross income, of the amount of work-related child and dependent care expenses you paid to a care provider. The credit can range from 20 to 35 percent of your qualifying expenses, depending upon your income.
For 2004, you may use up to $3,000 of the expenses paid in a year for one qualifying individual, or $6,000 for two or more qualifying individuals. These dollar limits must be reduced by the amount of any dependent care benefits provided by your employer that you exclude from your income.
As with all good things, there are some limitations on the amount of credit you can claim. If you received dependent care benefits from your employer, other rules apply. For more information on the Child and Dependent Care Credit, see IRS Publication 503, “Child and Dependent Care Expenses.”
Adoption Credit
Adoptive parents can take a tax credit of up to $10,390 for qualifying expenses paid to adopt an eligible child (including a child with special needs). For more information, see IRS Publication 968, “Tax Benefits for Adoption.”
EDUCATION BENEFITS
Income that is not subject to taxation includes certain distributions from education saving accounts, tuition savings programs, and interest on qualified savings bonds.
Coverdell Education Savings Account (ESA): Distributions that don’t exceed the beneficiary’s qualified education expenses are not taxed. Primary or secondary school expenses are eligible for ESA benefits. The beneficiary must be under age 18 when an ESA contribution is made; the annual contribution limit is $2,000 and is reduced if the contributor’s income is between $95,000 and $110,000 (between $190,000 and $220,000 for married filing jointly).
Qualified Tuition Program: Distributions from state- or educational institution-sponsored programs are not taxed to the extent used for qualified education expenses.
Education Savings Bond: Interest on qualified U.S. Savings Bonds is tax-free if proceeds are used to pay qualified education expenses and income is under $59,850 ($89,750 for married filing jointly). The exclusion phases out as income rises to $74,850 ($119,750 for married filing jointly).
In addition to tax-free income for education, there are education credits for higher education and tuition
deductions.
Hope Scholarship Credit: Up to $1,500 credit per eligible child for qualified education expenses incurred during the first two years of an undergraduate degree program. The amount of the credit is phased out based upon your modified adjusted gross income with the phase out beginning with joint incomes that exceed $85,000.
Lifetime Learning Credit: Up to $2,000 per return for an unlimited number of years for qualified post secondary education, even if such studies are not part of a degree program. The credit phase out is the same as the Hope Scholarship Credit.
Tuition and Fees Deduction: A deduction for qualified educational expenses paid during the year for yourself, your spouse, or a dependent up to $4,000. The deduction begins to be phased out with joint incomes exceeding $130,000.
Student Loan Interest Deduction: Up to a maximum of $2,500 in interest payments made on qualified student loans may be deducted. The amount of interest that may be deducted is phased out based upon your modified adjusted gross income beginning with joint incomes that exceed $100,000. For more information on the benefits of higher education see IRS Publication 970.
OTHER FAMILY TAX ISSUES
Gift-Giving
If you gave any one person gifts valued at more than $11,000 in 2004, it is necessary to report the total gift to the Internal Revenue Service. You may even have to pay tax on the gift.
The person who receives your gift does not have to report the gift to the IRS or pay gift or income tax on it.
You make a gift when you give property, including money, or the use of income from property, without expecting to receive something of equal value in return. If you sell something at less than its value or make an interest-free or reduced-interest loan, you may be making a gift.
If you are married, both you and your spouse could each have given up to $11,000 to the same person in 2004 without being liable for gift taxes.
For more information, see IRS Publication 950, “Introduction to Estate and Gift Taxes”; IRS Form 709, “United States Gift Tax Return”; and “Instructions for Form 709.”
Tax on a Child’s Investments
Part or all of a child’s investment income may be taxed at the parent’s rate rather than the child’s rate, according to the IRS. Because a parent’s taxable income is usually higher than a child’s income, the parent’s top tax rate will often be higher as well.
This special method of figuring the federal income tax only applies to children who are under the age of 14. For 2004, it applies if the child’s total investment income for the year was more than $1,500. Investment income includes interest, dividends, capital gains, and other unearned income.
To figure the child’s tax using this method, fill out Form 8615, “Tax for Children Under Age 14 With Investment Income of More Than $1,500,” and attach it to the child’s federal income tax return.
More information can be found in IRS Publication 929, “Tax Rules for Children and Dependents.”