Turn Saving Taxes into a Family Tradition
Raising children and supporting their educational goals can be fulfilling but also costly. Fortunately, several tax breaks are available to reduce these financial burdens. By taking full advantage of credits, deductions, and other tax benefits, you can make saving taxes a family tradition.
Child, Dependent, and Adoption Credits
Child Tax Credit (CTC)
For each child under age 17, you may be able to claim a $2,000 credit.
The CTC phases out at higher income levels, but the income thresholds have been raised under the Tax Cuts and Jobs Act (TCJA), allowing more families to qualify.
Refundable up to $1,500, meaning you could get some or all of the credit even if you owe no tax.
Credit for Other Dependents (COD)
For dependents who don’t qualify for the CTC (such as a child over the age limit or an elderly parent), you can claim a $500 COD.
The COD is also subject to income-based phaseout.
Future Changes (2026 and beyond):
If no further Congressional action is taken, the CTC will be reduced by 50% and the phaseout ranges will decrease significantly. The COD may be eliminated.
Adoption Credit
If you adopt a child, you may qualify for the adoption credit or be eligible for an employer adoption assistance program exclusion, up to the applicable limit.
This credit is also subject to an income-based phaseout.
Dependent Care Breaks
Child and Dependent Care Credit
This credit helps offset the cost of child care (for children under age 13) or care for other qualifying dependents.
The credit is typically 20% of the first $3,000 for one child or $6,000 for two or more children, so the maximum credit is $600 for one child or $1,200 for two or more children.
Child and Dependent Care Flexible Spending Account (FSA)
You can contribute up to an annual limit to a child and dependent care FSA (offered by your employer) on a pretax basis. This account reimburses you for qualifying care expenses.
Expenses paid through an FSA cannot be claimed for the child and dependent care tax credit.
Employing Your Children
Tax Savings from Hiring Children
If you own a business, hiring your children can help save taxes:
Deduct their pay as a business expense.
Children can earn up to the standard deduction for singles without paying federal income tax.
If they contribute to a traditional IRA, they can earn additional amounts (up to the annual IRA contribution limit) without owing taxes.
Important: Children must perform actual work and receive reasonable pay in line with what you would pay nonfamily employees for the same work.
IRAs for Teens
Setting Up IRAs for Children
IRAs are an excellent way to get children started on the path to saving for retirement.
Traditional IRAs: Contributions are deductible but withdrawals are taxed.
Roth IRAs: Contributions are not deductible, but qualified distributions are tax-free.
Gift Tax Considerations
If your children or grandchildren are not interested in contributing to their IRAs, you can gift them up to the amount they are eligible to contribute. However, be aware of gift tax rules when giving contributions.
Gifts and the “Kiddie Tax”
Kiddie Tax Overview
The kiddie tax applies to children under 19 and full-time students under 24 (unless they provide more than half of their own support from earned income).
Unearned income (e.g., dividends, interest) is typically taxed at the parents’ tax rate, which can result in higher tax liability than if the child were taxed at their own rate.
Planning with the Kiddie Tax
The kiddie tax is designed to prevent parents from transferring income-producing assets to their children to take advantage of lower tax brackets. Before gifting such assets to children (or grandchildren), make sure to consider whether they will be subject to the kiddie tax.
529 Plans
A 529 plan is a tax-advantaged savings plan that allows families to save for education expenses. It offers two primary types: prepaid tuition plans and savings plans. Both provide significant tax benefits, but each has unique features that may suit different financial goals.
Benefits of 529 Plans
Tax-Deferred Growth: Contributions are not deductible on the federal level, but any growth within the plan is tax-deferred.
No Contribution Limits: There are generally no income limits for contributing to a 529 plan.
Control: You maintain control of the account even after the beneficiary reaches legal age.
Tax-Free Rollovers: You can make tax-free rollovers to another qualifying family member.
Prepaid Tuition vs. College Savings Plan
Prepaid Tuition Plan
Guaranteed Tuition: If you purchase a contract for four years of tuition, the plan guarantees that tuition will be covered at today’s rates, even if tuition increases before the beneficiary attends.
Limitations:
Doesn’t cover room and board.
Uncertainty if the beneficiary attends a different school.
College Savings Plan
Flexible Use: You can use funds for a variety of educational expenses:
Qualified postsecondary expenses: Tuition, fees, books, supplies, room, board, computer equipment, software, and Internet service.
Elementary and secondary school tuition: Up to $10,000 per year per beneficiary.
Student loan debt: Up to $10,000 per beneficiary.
Limitations:
Limited investment control: You are limited to the options provided by the plan.
Investment changes: You can only change investments twice per year (or when changing beneficiaries).
Advantages over Coverdell ESAs: A 529 plan allows you to select a different investment option with each contribution, and you can perform tax-free rollovers to another 529 plan every 12 months for the same beneficiary.
Jumpstarting a 529 Plan
To avoid gift taxes on contributions to a 529 plan:
Limit contributions to the annual gift tax exclusion or use part of your lifetime gift tax exemption.
Special Break: You can front-load five years’ worth of annual exclusion gifts into a 529 plan contribution in a single year, applying to each beneficiary.
This option is particularly useful for grandparents wishing to contribute large sums and achieve estate planning goals.
Increasing 529 Plan Flexibility
Some concerns about 529 plans include potential tax consequences if the beneficiary doesn’t attend college or doesn’t need all the funds for college expenses. Before 2024, your options for unused funds were limited to:
Rolling funds into another 529 plan for a different family member.
Paying taxes and a 10% penalty on nonqualified withdrawals.
New Flexibility Starting 2024:
$35,000 Lifetime Limit: Unused funds can now be rolled into a Roth IRA for the beneficiary, subject to these rules:
The 529 plan must be active for at least 15 years.
No recent contributions (last 5 years) or earnings can be rolled over.
The rollover is subject to Roth IRA contribution limits, but not the AGI-based phaseout.
Note: IRS guidance is pending, so it’s important to consult a tax advisor for updates.
Coverdell ESAs
Coverdell Education Savings Accounts (ESAs) also provide tax-deferred growth and tax-free withdrawals for qualified education expenses. However, they are better suited for specific needs:
Control: You have more flexibility in how the funds are invested.
Elementary and Secondary Education: You can use the funds for educational expenses beyond just tuition, such as supplies, uniforms, and tutoring.
Drawbacks of Coverdell ESAs:
Low Contribution Limit: You can contribute only up to $2,000 per year.
Income Limits: Contributions are subject to income-based limits.
Age Limit: The beneficiary must use the funds by age 30, or the remaining balance must be distributed within 30 days. Earnings are subject to tax and a 10% penalty.
Education Credits
If you’re paying for higher education for yourself or your children, you may qualify for education credits that can reduce your tax liability.
American Opportunity Tax Credit (AOTC)
Credit Amount: Up to $2,500 per student per year.
100% of the first $2,000 of tuition and related expenses.
25% of the next $2,000 of expenses.
Eligibility:
Available for the first four years of postsecondary education.
Pursuit of a degree or recognized credential.
Refundable: Up to $1,000 of the AOTC may be refundable, meaning you can receive it even if you don’t owe taxes.
Lifetime Learning Credit (LLC)
Credit Amount: Up to $2,000 per tax return.
Eligibility:
Available for education beyond the first four years of college (for example, graduate school or continuing education).
This is a nonrefundable credit, meaning it can only reduce your tax liability to zero, but not beyond.
Both credits can be claimed in conjunction with tax-free distributions from 529 plans or Coverdell ESAs, provided that the same expenses aren’t used to claim both.
Income-Based Phaseouts:
Both credits are subject to income-based phaseouts, so high-income earners may not qualify.
Student Loan Breaks
If you’re paying off student loans, there are a few options for tax breaks that can help reduce your tax burden:
Student Loan Interest Deduction
You can deduct up to $2,500 of student loan interest each year, regardless of whether you itemize deductions.
Income-Based Phaseout: This deduction is subject to income limits.
Employer-Provided Student Loan Repayment Assistance
If your employer helps pay off your student loans, you may be eligible to exclude up to $5,250 of that assistance from income each year.
Expiration: This tax break expires after 2025.
Student Loan Forgiveness
Forgiven Debt: Generally, forgiven student loan debt is taxable as income.
Tax-Free Forgiveness: Under the CARES Act provisions, student loan debt forgiven after Dec. 31, 2020, and before Jan. 1, 2026 is tax-free.
State Taxes: Some states may still tax forgiven student loan debt, so be aware of state-level taxation.
ABLE Accounts
ABLE (Achieving a Better Life Experience) accounts are designed to help individuals with disabilities save for qualified expenses.
Eligibility: The beneficiary must have become disabled before age 26.
Tax Treatment: ABLE accounts are treated similarly to 529 plans for federal tax purposes.
529 to ABLE Account Rollovers
Through 2025, you can roll over funds from a 529 plan to an ABLE account without penalties, as long as:
The 529 plan beneficiary or a family member of the beneficiary owns the ABLE account.
Rollover amounts count toward the annual contribution limit for the ABLE account.