2001FINANCIAL GUIDE

Let your kids save you money, for a change

Raising a family costs plenty, but these tax tips may lessen the price.

By Michael Pretzer
Senior Editor

Estimates of the cost of raising children roll in regularly. $200,000. $300,000. $400,000. Yes, before they're grown, your precious bundles are going to cost you a bundle.

Columnist Kimberly Lankford, speculating in Kiplinger's Personal Finance, put the 18-year tab for parents who earn $62,000 or more annually and had a baby at the beginning of this year at $115,500 for housing, $48,000 for food, $42,000 for transportation, $32,500 for child care and schooling, $19,500 for clothing, $17,500 for health care, and $39,500 for video rentals and other miscellaneous stuff.

Private college? That'll set you back another $245,000 or so.

Projections such as Lankford's are unreliable. Who really knows what the economy will be like over the next 10 or 20 years? Besides, it's possible that some of your expenses, such as for housing, would be the same whether or not you had kids.

Still, the numbers are scary.

The federal government is sympathetic—up to a point. The tax code offers a handful of credits for children and presents opportunities to lighten the family tax burden by shifting income to the kids. But most doctors earn too much to be eligible for some credits, such as the Hope Scholarship and Lifetime Learning credit (see Tax breaks for lower-income physicians), and their children may be subject to the so-called kiddie tax. For higher-income families, then, the comfort they receive from the government depends on cunning financial planning.

Use a flexible spending account for child care

All parents, regardless of income, are eligible for what's called the dependent care credit. The credit can be as high as 30 percent of child care expenses up to $2,400 for one child and $4,800 for two children or more. But parents who earn more than $28,000 are permitted to take only a 20 percent annual credit, for a maximum of $480 for one child or $960 for two or more. The child must be younger than 13, and the care must be given so the parents can work or go to school.

Instead of taking the dependent care credit, you might be better off enrolling in an employer-based dependent care spending program. If your practice offers such a benefit—also known as a flexible spending account—you can set aside up to $5,000 annually to pay for child care. This doesn't just reduce your adjusted gross income. According to Dana G. Sippel, a senior financial adviser with Sullivan, Bruyette, Speros & Blayney, a financial consulting firm in McLean, VA, "it's a better deal because you pay no federal or state income tax and no Social Security or Medicare tax on the money." (In New Jersey and Pennsylvania, monies in a flexible spending account are not exempt from state tax.)

The flexible spending account is also a better deal for your practice. It doesn't have to fork over payroll taxes on an employee's deferred $5,000. "Physicians can save money as an employer and an employee," explains Sippel.

Consider transferring some investments to your kids

Congress established the kiddie tax more than a decade ago to keep grownups from sheltering taxable investment income under their children's names. The tax applies only to unearned income received by children under 14. The child's first $700 of investment income is tax-free, protected by his or her standard deduction. The next $700 is taxed at the child's rate—usually 15 percent. But the rest is taxed at the parents' rate—possibly as high as 39.6 percent.

If you're in the top tax bracket, you'll save less than $450 a year by putting investments in your child's name. And you'll lose control of the investments once your child turns 18 or 21 (depending on state law).

Still, there are instances when shifting investments to a minor may be a good idea. Say a high AGI disqualifies you for a Roth or education IRA, or an education tax credit. By transferring investments out of your name, you may get your AGI low enough to be eligible for the IRA or tax credit.

If you do decide to transfer investments to your children, you can avoid the kiddie tax by purchasing tax-exempt bonds or Series EE US savings bonds. The bonds won't make you a fortune, but they aren't taxed until they mature, which will probably be after your youngsters are beyond the age when the kiddie tax applies.

Put your offspring on the payroll

"If you consider income on the basis of the family unit," says Stephen Thomas, a tax lawyer and a partner in Fritsche & Thomas in Vienna, VA, "you'll understand the wisdom of moving income from family members in the highest tax bracket to those in the lowest."

Inevitably, that means transferring some of your income to your kids. But how?

Put the kids to work in your office—assuming you're in a solo practice or have partners agreeable to the idea.

Anyone can earn as much as $4,400 before starting to pay federal income tax and as much as $26,250 in 2000 before the rate rises above 15 percent. "Imagine that you pay your kid $20,000 a year," says Thomas. "If you're at the top rate of 39.6 percent, the income shift will save you more than $5,500 annually—a nice piece of change that starts to add up over several years."

Hiring the kids shrinks your AGI and creates deductible business expenses (wages and payroll taxes, and the value of any benefits you provide) for your practice. And, if it's a sole proprietorship, the practice doesn't have to pay Social Security and Medicare payroll taxes on family employees under 18, or federal unemployment taxes until age 21.

Adding a son or daughter to the payroll opens up other opportunities. For example, if your practice has a retirement plan, your child is eligible. If the practice's offering is a money-purchase or profit-sharing retirement plan, where you as employer make a contribution—rather than a 401(k) plan, in which some of the kid's salary is withheld—so much the better. Your practice can contribute up to 25 percent of a child's annual salary to his retirement and claim it as a business expense. Moreover, each year your kid may contribute $500 of the earned income to an education IRA or $2,000 to a Roth IRA.

One caveat: While these techniques can reduce taxes, they can also mean less financial aid when it's time for your son or daughter to go to college. When calculating eligibility, schools assume that a child can contribute a much higher percentage of his assets to college costs than his parents can. On the other hand, if you're earning enough for these methods to save you much taxes, your kid may not qualify for financial aid, anyway.

Tax breaks for lower-income physicians

If you're a resident or just starting out in practice, you might be eligible for some child-related tax breaks that aren't available to high earners.

For instance, parents with children under age 17 are eligible for a credit of $500 per child. But that credit starts to shrink when joint adjustable gross income reaches $110,000, and it disappears when AGI exceeds $110,000 plus $10,000 per child. (If you have four children, say, you'll lose the credit when your AGI exceeds $150,000—$110,000 plus four times $10,000.)

A much bigger credit—as much as $5,000 per child—is available to couples who adopt a child younger than 18. But the credit, given to defray adoption expenses, is phased down to zero for those with an AGI between $75,000 and $115,000.

Two other tax credits, which are available to help families finance their children's college education, are phased out on joint AGIs between $80,000 and $100,000. Moreover, you can't take the credits simultaneously for the same student.

The Hope Scholarship tax credit is calculated as 100 percent of a student's first $1,000 of tuition and fees and 50 percent of the second $1,000. So the maximum tax credit is $1,500 annually. This credit is good only during the first two years of college, but it's not limited to a specific number of students in the same family.

The Lifetime Learning tax credit is equal to 20 percent of tuition and other college expenses up to $5,000. The max is $1,000 annually. There's no restriction on the number of years the credit can be used, but it's limited to one per family.

In addition to the two education credits, the tax code allows you to contribute $500 to an education IRA for a child younger than 18. But these accounts are of limited value, because the amount is puny, eligibility is phased out on joint AGIs between $150,000 and $160,000, and a student can't tap into the IRA and be eligible for the Hope or Lifetime credit during the same year. If, however, you wish to set up an education IRA but are stopped because of a high AGI, a relative or friend with a qualifying AGI can make the contribution instead.

 

Michael Pretzer. Let your kids save you money, for a change. Medical Economics 2000;21:155.