The birth or adoption of a child brings joy to parents, grandparents, and other family members and friends. It also means financial challenges for families. According to the U.S. Department of Agriculture’s latest figures, it costs $233,610 to raise a child through age 17. And then there’s the cost of higher education that many parents and grandparents pay for in full or in part. The following are some of the tax, legal, and financial opportunities and concerns that are created when bringing a new child into the family. This column reflects changes made by the Tax Cuts and Jobs Act of 2017 (TCJA).
Tax breaks for a new child
When a child is born in a U.S. hospital, it is routine for a parent to complete a form used to obtain a Social Security number for the child. If a child is born elsewhere, the parent should apply for a child’s Social Security number. This is needed for various tax reporting purposes (as explained below) and for beneficiary designations of certain accounts and benefits plans.
In some cases, a Social Security number cannot be obtained for the child. A taxpayer should obtain from the IRS a taxpayer identification number that can be used instead:
Dependency exemption. A new child entitles parents to claim a dependency exemption. Usually, a child must live with a taxpayer for more than half the year, but in the case of birth, the child is treated has having met this requirement if he or she lived with the taxpayer for more than half the time he or she was alive. Any required hospital stay is disregarded. Thus if a child is born on December 31, 2017, the parent can claim a dependency exemption for 2017. No proration of the exemption amount is required.
An adopted child is treated as the taxpayer’s own child. This rule applies to a child who is lawfully placed with the taxpayer for a legal adoption.
The parent must have a Social Security number or other taxpayer identification number (TIN) in order to claim a dependency exemption. It usually only takes about two weeks for the Social Security Administration to issue an SSN, so even if a child is born late in the year the SSN should be available when a return is filed. But if one has not been received by the due date of the return, ask for a filing extension to gain more time to obtain the TIN.
As a practical matter, a high-income taxpayer may not fully or partially benefit from a dependency exemption for a newborn because of the phase-out in exemption amounts.
As a result of the dependency exemption and other tax breaks that may be claimed with respect to the new child, a parent may want to revise wage withholding and/or estimated taxes.
Child tax credit. A taxpayer with a qualifying child can take a tax credit of up to $1,000 each year. There is no limit on the number of children for whom the credit can be claimed. However, there is a modified adjusted gross income (MAGI) limit of $110,000 for married filing jointly, $75,000 for singles, heads of households, and qualifying widow(er)s; the limit is $55,000 for married filing separately.
A qualifying child is a person under the age of 17 by the end of the year who is a U.S. citizen, national, or resident alien that did not provide more than half of his/her support and lived with the taxpayer for more than half a year. Clearly a newborn meets this age requirement and is treated as meeting the more-than-half-a-year test if he or she lived with the taxpayer for more than half the time of being alive. As in the case of the exemption amount, the amount of the credit need not be prorated merely because the child was not alive for the full year.
If the credit is more than the amount of tax liability, the excess may be treated as an additional child tax credit, which is refundable. Essentially, the additional child tax credit is 15% of earned income over $3,000. The additional child tax credit can also be claimed by a family with less earned income but with three or more children if they paid Social Security tax (through FICA or self-employment tax) over $3,000.
If a Social Security number (SSN) for the child has not been issued by the due date of the return, including extensions, the child tax credit cannot be claimed on an original or amended return. This is so even if the SSN is later obtained.
The child tax credit is figured on a worksheet in the instructions to the return. The additional child tax credit is figured on Form 8812, Additional Child Tax Credit.
Dependent care. Parents who work can take a tax credit for dependent care expenses for the care of a qualifying individual. A qualified individual for purposes of the credit includes a child under age 13, so a newborn counts.
For 2017, the maximum amount of expenses paid during the year that are taken into account in figuring the credit is $3,000 for one child, or $6,000 for two or more children. The percentage applied to eligible expenses to determine the credit ranges from 28% to 20%, depending on adjusted gross income.
Payments to a taxpayer’s spouse, parent, child under the age of 19, or a dependent claimed by the taxpayer cannot be taken into account. Payments to another relative, such as a grandparent, may be taken into account. However, the relative must report the payments as income. If the care is in the parent’s home, the parent is an employer liable for the “nanny tax,” although wages to grandparents are exempt from this tax (IRS Publication 926). This tax credit is figured on Form 2441, Child and Dependent Care Expenses. The IRS requires the SSN or other tax identification number for each qualifying child.
Earned income tax credit. Those who work but have modest earned income may be eligible for a refundable tax credit based on income and the number of qualifying children, if any. The credit is barred if unearned income exceeds a set limit (e.g., $3,450 in 2017). When a child is born during the year, he or she can be a qualifying child for purposes of the earned income tax credit.
To be a qualifying child, the child must be the taxpayer’s dependent under the age of 19 (24 if a full-time student) and live in the taxpayer’s home for more than half the year. Once again, a child born during the year can satisfy this requirement. And no proration of the credit amount is required.
There must be an SSN for a qualifying child. An ITIN or ATIN cannot be used for the earned income tax credit.
Eligibility for the credit is figured on Schedule EIC, Earned Income Credit. The credit is taken from an IRS table (which is built into tax return preparation software).
Pending changes. Congress is considering eliminating the dependency exemption but increasing substantially increasing tax credits for children. What the changes will be and when they would go into effect remains to be seen.
Saving for education
According to U.S. News, the average tuition and fees for 2017-2018 are $34,699 at private schools, $21,632 at public schools for out-of-state students, and $9,528 for public in-state students. This doesn’t include room and board, books, transportation, and other costs of attendance. Parents and grandparents may be able to pay some or all of the costs by saving ahead.
529 plans. Referred to a qualified tuition programs, they include a prepaid plan to cover tuition and fees for higher education or a savings plan that can be used for a variety of college or graduate school costs. Plans are offered by all states. There is also a consortium of private educational institutions offering a prepaid tuition plan.
For federal income tax purposes, no deduction is allowed for annual contributions, but earnings are tax deferred. Distributions for qualified higher education costs are tax free. Unused amounts in an account can be transferred tax free to another beneficiary. Many states provide a deduction or credit to residents for state income tax purposes for their contributions.
The tax law does not limit the amount of annual contributions; the plan does. For example, New York’s savings program in 2017 has a cap of $520,000 per beneficiary; once the cap is reached no additional contributions can be made until the cap is raised. However, contributions in excess of the federal annual gift tax exclusion ($14,000 in 2017; $15,000 in 2018) are treated as taxable gifts for federal gift tax purposes. Under a special rule, contributions of five times the exclusion amount can be gift tax free. Thus, for example, a grandparent with three grandchildren could remove gift tax free up to $210,000 ($70,000 per grandchild) in 2017, thereby reducing the size of his/her estate. This strategy may become meaningless if federal estate and gift taxes are eliminated under pending tax reform proposals.
Multiple 529 accounts can be maintained for a beneficiary. For example, a parent may step up one plan and a grandparent may set up another. In theory, the lifetime cap on contributions applies across all accounts, but it is not clear how this is coordinated when accounts are maintained in different states.
Coverdell ESAs. This is an education savings plan that can be established for a beneficiary under the age of 18 (or someone of any age with special needs). Annual cash contributions can be made until the child reaches the age of 18. The contributor can be anyone...a parent, grandparent, aunt or uncle, or even a friend, as long as income is below set limits. No deduction for contributions is allowed, but earnings grow tax deferred and distributions for qualified education expenses are tax free.
The key benefit of this education savings program is the ability to use funds from the account tax free for a wide range of education, including grades K-12 at a public, private, or religious school, prep school, and/or higher education. Qualified expenses include, for example, academic tutoring and extended day programs provided at the school.
U.S. savings bonds. A parent may want to buy U.S. Savings bonds (series EE or I) with the idea that they’ll be redeemed to pay higher education costs. As long as parents are at least 24 years old when the bonds are purchased, they may qualify for an exclusion of interest when the bonds are redeemed (assuming their income in the year of redemption does not exceed a threshold amount). This tax break doesn’t apply to grandparents or others.
Tax savings strategies for education are explained in IRS Publication 970, Tax Benefits for Education.
Claiming tax breaks and saving for college aren’t the only concerns for a newborn.
Health insurance. A parent can add a child to his/her health insurance plan. In most cases, it means a phone call to the insurer and providing copies of a birth certificate and SSN. Once this is done, the plan covers the baby’s medical costs retroactively to the date of birth.
Employee benefit plans. An employee may become eligible for certain employee benefits with respect to a newborn or adopted child.
• Dependent care assistance. The employer may pay up to $5,000 annually for dependent care costs. Alternatively, an employer may offer a dependent care flexible spending arrangement (FSA) to which an employee can make pre-tax salary contributions up to $5,000 annually.
• Adoption assistance. Large employers may pay some or all of the costs of adoption (the tax law places a dollar limit on tax-free assistance).
Time off. An employee may be eligible under the Family and Medical Leave Act (FMLA) to take up to 12 weeks of unpaid leave for the birth or adoption of a child. States may provide more generous leave rules which supersede federal law. In a few states (California, New Jersey, Rhode Island, and starting January 1, 2018, New York), there is paid family leave time funded by employees’ payroll tax contributions.
Make beneficiary changes. A parent with life insurance policies, annuity contracts, retirement plans, and/or IRAs, may want to add the name of the new child. If an existing beneficiary designation is “my children,” then no change is required (but check with the plan’s or policy’s administrator, custodian, trustee, or other party.
Make or revise a will. If a parent has a will that names his or her children, be sure to draw up a new will to include the newborn. Again, if the will only says “my children,” no change may be necessary. If the
will says nothing about any children, a parent of a new child may want to specifically include the child’s name. The same is so for grandparents and other relatives who want to make provisions for a new child.
A parent may also want to name a guardian for the child in the will. This is the person who can raise the child and manage the child’s money in case there is no parent to do so. A parent can name two guardians, one to care for the child and another to handle financial matters for the child.
A wealthy parent or grandparent may wish to set up a trust for the child, during the creator’s life or to take effect at the time of the creator’s death.
The period when a new child enters the family is usually a hectic one. Routines are disrupted and new accommodations must be made. But don’t ignore the importance of addressing tax, financial, and legal issues. Consult with a knowledgeable financial advisor for help with these matters.
This article originally appeared in the April 2018 issue of The CPA Journal.
Sidney Kess is of counsel to Kostelanetz & Fink and a senior consultant to Citrin Cooperman. He is a member of the NYSSCPA Hall of Fame and was awarded the Society’s Outstanding CPA in Education Award in May 2015. He is also a member of The CPA Journal Editorial Advisory Board.
James Grimaldi is a tax partner with more than 30 years of experience providing strategic tax planning, research, and compliance services. His clients include business owners in a range of industries, including real estate, manufacturing, and family offices, as well as not-for-profits and high net worth individuals. He can be reached at 646-695-7873 or at email@example.com.
James Revels is a tax partner with more than 24 years of experience providing comprehensive, customized, and innovative services in the areas of planning, accounting, auditing, administration, trust, gift, estate, and income tax. He advises a broad range of clients, including early stage corporations, foreign corporations, bio-tech companies, not-for-profit organizations, high net worth individuals, executives, entrepreneurs, owners of closely held entities, and foreign individuals. He can be reached at 267-479-0161 or at firstname.lastname@example.org.