While many baby boomer grandparents are enjoying their long-awaited retirement years of travel, rest, and relaxation, many others are again raising a family. Growing numbers of grandparents are becoming the primary caregivers of grandchildren for a variety of reasons.
According to the last U.S. census, there were more than 2.7 million households with grandparents raising grandchildren and over 5.7 million grandchildren being raised by their grandparents (Coresident Grandparents and Their Grandchildren: 2012, U.S. Department of Commerce, Economics and Statistics Administration, October 2014, http://bit.ly/2b3HAL5). Over 60% of grandparents raising grandchildren are still in the workforce, and 22% of grandparents raising grandchildren earn an income that is below the poverty level (U.S. Census Bureau, 2013 American Community Survey, http://bit.ly/2bA0GtS). By all indications, these numbers will continue to rise. The majority of grandparents are usually middle class, but many struggle to make ends meet in their new “skip generation” context of raising grandchildren.
Fortunately, several tax provisions for grandparents in this situation help ease the financial burden of being the primary caregivers of grandchildren. This article discusses many of these opportunities. In addition, the Exhibit provides a recap of the various federal tax opportunities.
Federal Tax and Financial Opportunities for Grandparents Raising Grandchildren
Possible Tax Credits and Deductions
Dependency exemption for a grandchild.
If certain conditions are met, a grandparent can claim a dependency exemption for a grandchild as a “qualifying child” for income tax purposes. A qualifying child must meet several tests, including—
- relationship (for a grandparent, a grandchild is a descendant and passes this test),
- abode (grandchild must live with the grandparent for more than half the year),
- age (grandchild must be under the age of 19, or 24 if a full-time college student or disabled), and
- support (grandparent must provide more than half of the support for the grandchild).
In addition, the grandchild cannot be married filing a joint tax return and must be a U.S. citizen, a U.S. resident, or a resident of Canada or Mexico for some part of the year. For wealthier grandparents, when adjusted gross income (AGI) reaches a certain level, the exemption amount may be reduced or even eliminated. For 2016, a grandparent can claim up to a $4,050 exemption deduction per qualifying grandchild. The $4,050 exemption must be reduced 2% for each $2,500 of AGI over a certain level. For married grandparents filing separately, the exemption starts to phase out at $155,650; for unmarried individuals (other than surviving spouses and heads of households), at $259,400; for heads of households, at $285,350; and for married individuals filing jointly at $311,300 (Revenue Procedure 2015-53).
Head of household filing status.
For married grandparents, adding a grandchild as a dependent will not change the married filing jointly status, which is already the most beneficial tax rate schedule. An unmarried grandparent raising a grandchild, however, would now be able to claim head of household filing status, which offers greater tax savings than filing single. Note that the same tests for qualifying children (relationship, abode, age, and support) must be met.
Earned income tax credit.
A grandparent with earned income (i.e., still working) and a grandchild who meets the qualifying child definition may meet the criteria for the earned income tax credit (EITC). The grandchild must meet the requirements to be a dependent exemption, with the exception of the support test. The EITC, which is a refundable amount, varies based on the AGI of the grandparent and the number of grandchildren that qualify. Items that can negate qualifying for the EITC include a married filing separately tax status, having no earned income, and having too much unearned income.
For example, Mary is in her early 60s with a full-time job; she and her retired husband, Joe, are raising their 10-year-old grandson, Adam. In 2016, Mary and Joe filed jointly and reported $18,500 in salary for Mary (earned income), $5,000 in taxable Social Security benefits for Joe (not qualified for earned income), and $200 in interest income (investment income, not earned income). Since Adam lived with his grandparents for the entire year and was 100% supported, he is a qualifying child for EITC purposes. Based on the amount of earned income ($18,500), filing status (married filing jointly), and the number of qualifying children (one), Mary and Joe qualify for the EITC.
Child tax credit.
The child tax credit (CTC) of $1,000 may be available to grandparents as well and under specific circumstances could be refundable. The qualifying grandchild must be under age 17 and a U.S. citizen or resident alien, and the grandparents must qualify for the dependent exemption. The credit begins to phase out once the grandparents’ modified adjusted gross income (MAGI) reaches a certain level.
For example, Alison and Andrew are working full time and taking care of two granddaughters. All are U.S. citizens. In 2016, the couple received total wage income of $120,000 and had no other gross income. Both granddaughters were under age 17 in 2016 and qualified as dependents. Because Alison and Andrew’s MAGI ($120,000) exceeds the $110,000 threshold for married filing jointly, the maximum CTC of $1,000 for each qualifying child is reduced by $50 for every $1,000 over the threshold. As a result, the couple would lose $500 of the total credit, for a CTC of $1,500. Note that the CTC is generally not refundable and thus can only reduce the grandparents’ federal income tax owed and cannot be claimed if no tax is due.
Legal guardianship is not a requirement of the CTC. It should also be noted that income from retirement pensions and Social Security benefits do not qualify as earned income for purposes of the EITC and CTC. The EITC and CTC do not affect other government benefits such as food stamps, Social Security, or Medicare benefits.
Child and dependent care credit.
A working grandparent who pays for care of a dependent grandchild under the age of 13 or a physically or mentally disabled grandchild may qualify for the child and dependent care credit (CDCC). The grandchild must live with the grandparent for more than half the year. The amount of childcare spending that qualifies for the credit is up to $3,000 for one child and up to $6,000 for two or more children. The CDCC is then calculated on the spending amount (after applying the earned income limit) at a rate of 20–35%. This is also a nonrefundable credit.
For example, Amy is working a part-time job to help take care of her 7-year-old grandson, John. In 2016, Amy reported AGI of $14,000, all of which was earned income. Amy also paid $3,600 in after-school care expenses so she could go to work. John meets all the requirements as a dependent, and Amy can claim a total credit of $1,050.
Medical and dental expenses.
For a grandparent who itemizes deductions, medical and dental expenses paid on behalf of a grandchild during the year may be deductible. All medical expenses of the grandparents and grandchildren are added together and are allowed to the extent that they exceed 10% of AGI, or 7.5% of AGI for grandparents age 65 or older. These amounts would also include any unreimbursed costs of a grandchild attending a “special school” for being neurologically or physically handicapped.
Education Incentives and Expenses
College education tax credits.
Grandparents paying for a dependent grandchild’s college tuition expenses may qualify for two possible education tax credits: the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC). The AOTC (100% of the first $2,000 plus 25% of the next $2,000) relates to the grandchild’s qualifying expenses for the first four years of undergraduate college education (of which a portion could be refundable), while the LLC (20% of the first $10,000) relates to any qualified expenses of any post–high school education at “eligible educational institutions.” Again, the amount of the credit depends on the MAGI of the grandparents. For 2016, the AOTC phase-out ranges from $160,000 to $180,000 for married filing jointly and from $80,000 to $90,000 for other filing statuses. The LLC phases out from $110,000 to $130,000 for married filing jointly and from $55,000 to $65,000 for other filing status. Note that neither credit is available to married grandparents who file separately.
The CTC is generally not refundable and thus can only reduce the grandparents’ federal income tax owed.
For example, Amber filed a federal income tax return as head of household for 2016 reporting two dependent qualifying grandchildren, James and Jason. In 2016, Amber paid $3,000 tuition to the university James attended as an undergraduate sophomore and $1,000 for Jason, already a college graduate, to take an advanced Excel training class at a local college to improve his job prospects. Amber’s 2016 MAGI totaled $60,000. Both educational institutions qualify as eligible.
The entire $3,000 tuition paid for James is a qualified education expense for AOTC purposes, and Amber can claim a $2,250 credit. Amber cannot take the AOTC for Jason, who has completed his undergraduate education; however, she may claim the LLC for his training class, for a credit of $100 (reduced from $200) because Amber’s MAGI falls within the phaseout income range for head of household status.
A possible alternative is an above-the-line AGI deduction for interest on qualified education loans. This amount is up to $2,500 interest paid on qualified students’ loans. The grandchild must be enrolled at least half-time at the college. Again, for higher income grandparents, the ability for this deduction phases out once MAGI reaches a certain level.
Direct payment of tuition expenses.
Internal Revenue Code (IRC) section 2503c(1) provides the ability to make an unlimited, tax-free “qualified transfer” directly to the educational institution; this is not treated as a gift for gift tax purposes. That there are no restrictions regarding the educational institution, and the qualifying transfer applies to any educational tuition expenses, ranging from nursery school to graduate school. It does not include room, board, and books. In addition, the transfer is not subject to the generation-skipping transfer tax (GST).
Tax-advantaged federal 529 account plans.
An excellent way for a grandparent to contribute to a grandchild’s college education is to set up a 529 plan. Contributions grow income tax free, and withdrawals used for the beneficiary’s qualified education expenses are tax exempt at the federal, and usually state, levels. The funds can be used to cover tuition, room and board, books, and supplies.
There are two types of IRC section 529 plans: prepaid tuition plans and college savings plans. Prepaid tuition plans may be offered at the state level of an eligible educational institution (usually an in-state public university). This pre-paid program allows for payment in advance of college credits for the designated beneficiary. The enrollment periods and cost are established by the state. College savings plans are individual investment accounts offered by nearly all states and managed by various financial institutions. The income can be used at any accredited college in the United States or abroad. This plan allows the contributions to be made to the account on behalf of the designated beneficiary.
These plans can usually be established at any time from the grandchild’s birth up to beginning college. Additional funds can also be contributed to an already existing 529 account in regular amounts. Under special rules unique to 529 plans, grandparents can even make a single, tax-free lump-sum gift of up to $70,000 ($140,000 for joint gifts by married grandparents). A tax election must be made to treat the gift as if it were made in equal installments over a five-year period, and no additional gifts can be made to the beneficiary during this time.
Private elementary/secondary school.
A grandparent can contribute to a grandchild’s private elementary or secondary school education through a Coverdell education savings account (ESA), up to $2,000 per beneficiary each year. Similar to a 529 plan, the money grows tax free at the federal and state levels if used to pay the grandchild’s qualified education expenses, including private elementary and secondary school, as well as college. There are AGI limitations on who can contribute.
Trust options are available for a grandparent to fund a grandchild’s education or support. Examples include health and education exclusion trusts (HEET), where direct payment of educational or medical expenses is not subject to the GST tax; dynasty trusts; Crummey trusts; and IRC section 2503(c) trusts.
Early withdrawals from retirement plans.
This is probably not a preferred option, but younger grandparents can make an early withdrawal from an Individual Retirement Account (IRA) or borrow funds from a 401(k) retirement plan free of the 10% penalty to pay for a grandchild’s qualified college educational expenses.
Additional Tax-Free Options
There are also many tax opportunities available for grandparents in general who may or may not be raising a grandchild.
Annual gift tax exclusion.
A grandparent can make a tax-free gift of $14,000 per year for each grandchild. Married grandparents can contribute up to $28,000 per grandchild; known as gift splitting, this strategy requires the filing of a gift tax return even though no tax is due. These amounts are also exempt from any GST implications.
Flexible spending arrangements.
A flexible spending account (FSA) provides the ability to pay for eligible medical or dependent care expenses with an account that deducts pre-tax dollars from a paycheck. The grandparent chooses the amount to be deducted, and the funds are set aside to be used for eligible expenses throughout the year. There are two types of plans to choose from: healthcare FSAs (unreimbursed medical account) and dependent care FSAs. A healthcare FSA can reimburse or help pay for eligible healthcare expenses not covered by a health plan; the entire amount is available at the beginning of the year, even though it is deducted on a per-paycheck basis. In contrast, a dependent care FSA is not funded in advance, and the employee cannot receive reimbursement for the full amount of the annual contribution on day one. Dependent care FSAs can nonetheless help save an average of 30% on eligible dependent care expenses like preschool, summer day camp, before/after school programs, and daycare.
Health savings accounts.
Health savings accounts (HSA) combine pre-tax dollars with a qualified high-deductible health plan (HDHP) to help save money on eligible medical expenses. HSAs offer great flexibility, as well as tax-free contributions and distributions for eligible expenses. Other benefits include the allowance of carrying over a balance from year to year and accumulating interest in a money market account, the ability to stop and start an account or change the contribution amount at any time during the year, and the ability to choose when and how to reimburse from the account.
Starting over and raising a second family when a grandparent can be a financial shock. The tax programs and incentives discussed above can, however, greatly help grandparents who find themselves in such a situation provide their grandchildren with the care and education they need.