Tax Planning Strategies for Parents: Part I

As parents know, time is limited.  Our goal is to give new parents some tax planning ideas to implement before year-end. We will discuss this topic in two parts. 

• Part I will provide three to four actionable items new parents can put into effect before December 31.
• Part II will discuss tax planning strategies for new parents to implement before April 15, or by the time tax returns are filed, whichever comes first.

We will cover the basics for new parents on IRC Sec. 529 Plans, dependent care flexible spending account (FSA) vs. child and dependent care credit, and mortgage interest deduction.

What is a 529 Plan?

An IRC Sec. 529 plan is an investment plan designed to encourage saving for future education costs.  Many still believe that 529 plans can only be used to help pay for four-year colleges.  However, 529 plans can be used for a variety of institutions or programs including community college, trade or vocational schools, graduate school, certain apprenticeship programs and qualifying online courses. 

Contributions into a 529 plan are not tax deductible, but earnings grow tax-deferred and withdrawals are tax-free when used to pay for qualified higher education expenses (tuition, room and board, books, etc).

There are two types of 529 plans: prepaid tuition plans and education savings plans, but this article will only cover education savings plans.  Both types of 529 plans are administered by state agencies, and most states and Washington DC offer education savings 529 plans.  New parents can select which states’ plan to invest in, however, some states offer significant state tax benefits and other advantages for in-state residents.  These benefits may include but are not limited to state tax deductions and exemption from state financial aid calculations.  Contributions to a plan must be made by December 31 to receive a tax benefit (state tax deductions) for that calendar year.

529 plans can be opened by anyone, including parents, grandparents, other relatives and friends regardless of their relationship to the beneficiary.  Irrespective of the account owner, other individuals can contribute into an existing plan.  Finally, if the designated beneficiary does not end up using the 529 plan, another beneficiary can be named to the existing plan.  It is never too early or too late to start planning for your kid’s future and a 529 plan is a great vehicle to consider.  For additional information, the National Association of State Treasurers created the College Savings Plan Network and can be found at www.collegesavings.org.

Dependent Care Flexible Spending Account (FSA) vs. the Child and Dependent Care Credit

Two strategies families might consider to help supplement childcare costs are the dependent care flexible spending Account (FSA) and the child and dependent care credit.

A dependent care FSA is an employer-sponsored, pre-tax account. You set up automatic deductions from your paycheck that are contributed to this account and the funds are eligible to use for qualifying childcare expenses. The current maximum contribution is $5,000 per year for each household. Therefore, even if both you and your spouse have a dependent care FSA available through your individual employers, you can only contribute $5,000 total to one or across both accounts.

Potential benefits of a dependent care FSA

• Funded with pre-tax dollars, much like a workplace retirement plan. This helps to reduce your total taxable income, meaning you may pay less overall taxes as a result.
• Sheltered from the federal 7.65% Social Security and Medicare tax.
• In most cases, sheltered from state taxes as well.

As an example: If you contribute the maximum $5,000 in a given year, and fall into the 24% tax bracket, you would be saving about $1,583 a year in taxes including both federal income tax and the 7.65% Social Security and Medicare tax.

While the dependent care FSA has the potential stated benefits, there are a few drawbacks:

• Use-it-or-lose-it! Contributed funds do not roll over from year-to-year.  If your specific childcare plans change, then you may be out of the money you already contributed into the dependent care FSA.
• Not all employers offer dependent care FSA options.
• Make sure all your expenses qualify; this means tracking receipts, reimbursements, and other qualifying costs associated with childcare and making sure all childcare services are eligible for the funds in a dependent care FSA. For example, the cost of babysitters hired for care unrelated to your employer may not be qualified expenses for reimbursement.

Because a dependent care FSA does not offer year-to-year rollover, it is more important to carefully budget qualifying childcare related expenses for the given year (although it may not be hard to reach the $5,000 limit these days).

What is the Child and Dependent Care Credit?

Qualifying for the child and dependent care credit requires the following:

• Having work-related expenses for childcare. Childcare has to be necessary so that you can work. To prove this, the government requires that both parents provide proof of income. The exception to this rule is if a spouse is disabled or a full-time student.
• The care has to be for a dependent qualifying child who was under age 13 when the care was provided. A spouse or dependent who lives with the taxpayer for more than half the year and is either physically or mentally incapable of caring for themselves also qualifies.
• There is a limit to how much the credit is worth – which is typically between 20-35% of qualifying childcare costs. This percentage directly correlates with your income.

As of 2020, the total expenses you can claim are $3,000 for one child and $6,000 for two or more children. The credit starts at 35% for the lowest income earners and gradually drops down to 20% for high-income earners.  So regardless of how much you pay in childcare costs, the potential maximum child and dependent care credit is $600 to $1,050 if you have one child, or $1,200 to $2,100 if you have two children or more.

Remember to deduct any financial help your employer offers for childcare prior to calculating your credit. Occasionally, an employer will provide a childcare stipend, and that amount does not count toward your tax credit.

Potential benefits of using the Child and Dependent Care Credit

The child and dependent care credit can be a great option for new parents looking to reduce the impact childcare costs have on their monthly expenses. A few benefits of this tax credit are:

• It’s a direct way to lower the amount of taxes owed as tax credits reduce taxes dollar-for-dollar.
• If your family earns less than $43,000 a year, this tax credit may provide a larger benefit to you than a family who owes more.
• The child and dependent care credit is an excellent way for individuals without a dependent care FSA option to offset some childcare expenses for their family.

Potential disadvantages of the Child and Dependent Care Credit

Although saving money on taxes may feel like it is always a good idea, there are a few drawbacks to the child and dependent care credit to keep in mind.

• Limits on the child and dependent care credit are lower than what many families spend each year on childcare.
• If you are a family that earns over $43,000, the tax benefits that come with using a dependent care FSA may save your family more money than the child and dependent care credit.

Can I use both the Child and Dependent Care Credit and a Dependent Care FSA?

With both of these money saving options available, you might be wondering if you can take advantage of these two simultaneously to maximize savings. In most cases, you may have to choose only one option for your family, but there are some exceptions. For example, if your family has two or more kids and you have already maxed out your dependent care FSA $5,000 limit, and your qualifying childcare expenses hit or exceed the $6,000 cap for the child and dependent care credit, you can take advantage of both – but the child and dependent care credit will only be applicable on the $1,000 that was “unreimbursable” from your dependent care FSA. Therefore, if your income puts you in the 20% credit range, this could save you another $200 on taxes.

What is the Mortgage Interest Deduction?

If you are a new parent, you may also be a (relatively) new homeowner. The mortgage interest paid on your home’s mortgage is deductible as an itemized deduction without limitation if the principal balance of your mortgage is under $750,000 if married filing jointly or $375,000 married filing separately, if the mortgage was taken out after December 15, 2017. Prior to December 15, 2017, the limitation is $1,000,000 for married filing jointly or $500,000 for those married filing separately. You may also be able to deduct the interest on a home equity loan. Due to a law change effective starting in 2018, the standard deduction increased greatly. This increase in the standard deduction made it less likely for new parents to itemize their deductions.

A way new homeowners can make the most of the standard deduction and itemized deductions is to bunch deductions up into alternating years. You may take the greater of the standard deduction or itemized deduction, however, not both.  You can plan to itemize or take the standard deduction by paying your January 1 mortgage payment early in December or in January. You are eligible for the interest deduction in the year that it is paid. As an example, you may want to make thirteen mortgage payments in one year, ensure you have met the state and local (SALT) cap of $10,000, and make your maximum charitable contributions to ensure a large itemized deduction. In the following year, make eleven mortgage payments and less charitable contributions (since you front loaded them in the prior year). This way you are reducing your deductions but still take the current standard deduction.