Thanks to the pandemic, we have an extra month until we have to file taxes for 2020, so there is still time to refine your tax strategy. Don’t forget to include your kids in your tax planning. The rules change when tax planning with dependents, so it pays to review the tax regulations centered around claiming your children or other relatives as dependents.
Because 2020 was a disruptive year for all of us, there may be changes in how you approach tax planning with dependents, especially when it comes to deductions. If you were working from home, for example, it could have an impact on childcare costs or other deductions that you may have had in the past.
The Internal Revenue Service (IRS) has a clear definition of who they consider to be a dependent for tax purposes. A dependent is someone other than the taxpayer or the taxpayer’s spouse who can be claimed as a dependency tax deduction. A dependent can either be a child or a relative who cannot be claimed on another taxpayer’s return and who does not file their own taxes.
For example, if you are divorced, the custodial parent typically claims dependent children on their taxes because both parents can’t claim the same children. Dependent children also have to be under the age of 18, or full-time students under the age of 24. An elderly parent can also be claimed as a dependent if they have lived with you for more than six months, are a citizen, and have not earned more than the gross income limit.
When reviewing your tax strategy, there is an important distinction to make between a tax deduction and a tax credit. A tax credit reduces what you owe in taxes by giving you a dollar-for-dollar credit to lower your tax liability. A tax deduction reduces the amount of your taxable income. A tax credit is preferable because you save more money.
Let’s consider an example to illustrate the difference. Let’s assume an income of $100,000 and a tax rate of 25% with a tax deduction of $10,000 versus a tax credit of $10,000.
Tax deduction:
($100,000 income – $10,000 deduction = $90,000) x 25% tax rate = $22,500 in total tax
Tax credit:
($100,000 income x 25% tax rate) = $25,000 in tax - $10,000 credit = $15,000 in total tax
Clearly, you get more money back from a tax credit.
The stimulus checks paid in 2020 and 2021 are considered tax credits because the income is not taxable. Adoption-related expenses can also be considered tax credits. Expenses for dependents, however, are considered tax deductions.
There is a child tax credit for children under age 17. Taxpayers get a $2,000 credit for every eligible dependent child in 2020, and that child credit will increase to $3,000 per child under 18 in 2021. If you are filing taxes for 2020, you also can claim an additional child tax credit using your 2019 income—if you owe less in taxes than the available child tax credit, then you may be able to claim up to $1,400.
Tax rules continue to change, especially with the passing of the American Rescue Plan, so refamiliarize yourself with current tax codes. For example, the American Rescue Plan includes tax-free economic impact payments that you can claim, even if you didn’t receive the payment; a new child tax credit ranging from $2,000 to $3,600; and new tax waivers on unemployment benefits,
You would think that additional costs, such as homeschooling, would be tax-deductible. Unfortunately, in Washington and Oregon, homeschooling is not tax-deductible. The only states to allow deductions for homeschool are Illinois, Louisiana, and Minnesota.
However, college students are generally considered dependents if they are under age 24, full-time students, and you pay more than half of their living expenses. Because of this, you can deduct up to $4,000 of college tuition costs if your adjusted gross income is less than $65,000 as a single filer, or $130,000 if you are married and filing a joint return. This deduction covers expenses such as tuition, books, activity fees, and other costs directly related to education. It does not cover room and board, insurance, transportation, and living expenses.
One way to reduce college expenses and save on taxes is with a college savings plan. For example, a 529 plan is a tax-advantaged savings plan, similar to an Individual Retirement Account (IRA), that you can use to put aside money to pay for tuition. Another option is a Prepaid Tuition Plan that allows you to purchase credits at participating colleges to pay for tuition and expenses. And with an Education Savings Plan, you can create an investment account and pay up to $10,000 per year toward future college expenses.
If you aren’t sure how to plan for your taxes, including potential deductions for dependents, then opt to be conservative and set aside money for the worst-case scenario. Save as much as you can for next year’s taxes, so that you have options before you have to file. If you start saving now, you will have enough to pay the taxes or invest in an IRA or 529 plan account to reduce your tax bill.
Be sure to allocate tax savings as part of your monthly household budget. To help you get started, download our Budgeting Checklist so you can map out your savings plan. You will also want to have a savings account to set aside your tax savings and make the most of any cash you may get back as a tax refund.
We can assist you with your tax planning. Be sure to visit one of our local iQ Credit Union branches and speak to a member advisor or member service officer about opening a savings account and developing a savings plan as part of your tax strategy. iQCU is committed to helping our members prepare for whatever their financial future may hold.