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 (Mark Lino, Kevin Kuczynski, Nestor Rodriguez, and TusaRebecca Schap, Expenditures on Children by Families, 2015, January 2017, http://bit.ly/2BIm10P), it costs $233,610 to raise a child through age 17—and this does not include the cost of higher education. The following are some of the tax, legal, and financial opportunities and concerns 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 the form used to obtain a Social Security number (SSN). If a child is born elsewhere, the parent should apply for an SSN, which is needed for various tax reporting purposes (as explained below) and for beneficiary designations of certain accounts and benefits plans.
In some cases, an SSN cannot be obtained for the child; the taxpayer should then obtain from the IRS one of the following:
- ITIN (Individual Taxpayer Identification Number), for a child who is not a U.S. citizen or resident alien (e.g., a child in Canada or Mexico), or
- ATIN (Adoption Taxpayer Identification Number), for a child placed with the taxpayer for adoption.
Under the Tax Cuts and Jobs Act (TCJA), the dependency exemption has been eliminated for federal income tax returns for 2018 through 2025; on 2017 federal income tax returns, however, a child entitles parents to claim a dependency exemption. Usually, the child must live with the taxpayer for more than half the year, but in the case of birth, the child is treated has having met this requirement if he lived with the taxpayer for more than half the time he was alive, with any required hospital stay disregarded. Thus, even if a child was born on December 31, 2017, the parent can claim the dependency exemption for 2017. No proration of the exemption amount is required. A child lawfully placed with the taxpayer for a legal adoption is treated as the taxpayer’s own child.
The parent must have an SSN or other taxpayer identification number (TIN) in order to claim a dependency exemption. It usually takes approximately 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. If one has not been received by the due date of the return, ask for a filing extension.
As a practical matter, a high-income taxpayer may not fully or partially benefit from a dependency exemption for a newborn because of the phaseout of exemption amounts on 2017 returns.
Child tax credit.
There is a special tax credit that can be claimed for having a child; however, the rules that apply for 2017 returns have been dramatically enhanced by the TCJA for 2018 through 2025.
Tax credit for 2017.
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 couples filing jointly; $75,000 for singles, heads of households, and qualifying widows and widowers; and $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, did not provide more than half of 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 she lived with the taxpayer for more than half the time she was 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 the taxpayers paid Social Security tax (through FICA or self-employment tax) over $3,000.
If an 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, even if the SSN is obtained later.
Tax credit for 2018 through 2025.
The credit amount has been doubled to $2,000 per qualifying child, and the income phase-out levels have been increased to $400,000 for joint filers and $200,000 for other filers. The credit is refundable up to $1,400, and the earned income threshold for the refundable portion of the credit has been lowered to $2,500.
There is also a $500 nonrefundable credit that can be claimed with respect to a person who would have been a qualifying dependent under the pre-2018 rules. This would include, for example, a disabled child who is 22 years old and living with parents who support her.
The child tax credit is calculated on a worksheet in the instructions to the return. The additional child tax credit is calculated on Form 8812, Additional Child Tax Credit.
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 qualifies.
The maximum amount of expenses paid during the year 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 (AGI).
Payments to a taxpayer’s spouse, parent, child under the age of 19, or claimed dependent 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 paid to grandparents are exempt (IRS Publication 926, Household Employer’s Tax Guide, Jan. 23, 2018, http://bit.ly/2o1DVTc).
This tax credit is calculated 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 ($3,450 in 2017; $3,500 in 2018). When a child is born during the year, he 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 satisfies 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 calculated on Schedule EIC, Earned Income Credit. The credit is taken from an IRS table, which is built into tax return preparation software.
Saving for Education
According to U.S. News & World Report (Farran Powell, “Explore the Costs of Attending College,” Sept. 12, 2017, http://bit.ly/2BFCMd4), 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 at public schools for in-state students. This does not 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.
Referred to as qualified tuition programs, IRC section 529 plans encompass prepaid plans to cover tuition and fees for higher education or savings plans that can be used for a variety of college or graduate school costs (as well as limited amounts for primary and secondary school starting in 2018, as explained below). Plans are offered by all states. There is also a consortium of 300 private educational institutions offering a prepaid tuition plan (http://bit.ly/2EYtCKO).
For federal income tax purposes, no deduction is allowed for annual contributions to such plans, but earnings are tax deferred. Distributions for qualified education costs are tax-free, including distributions up to $10,000 for primary and secondary school starting in 2018. 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.
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. Contributions in excess of the federal annual gift tax exclusion ($14,000 in 2017; $15,000 in 2018), however, 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 up to $210,000 ($70,000 per grandchild) in 2017 or $225,000 ($75,000 per grandchild) in 2018, thereby reducing the size of her estate.
Multiple 529 accounts can be maintained for a single beneficiary. For example, a parent may set 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.
These are education savings plans 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 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, at a preparatory school, or for higher education. Qualified expenses include, for example, academic tutoring, and extended day programs provided at the school. The TCJA did not make any changes to Coverdell ESAs, but with the new option to use funds from 529 plans to pay tuition at primary or secondary schools from 2018 through 2025, the need for a Coverdell ESA is less acute.
U.S. Savings Bonds.
Parents may want to buy U.S. Savings Bonds (series EE or I) with the goal of redeeming them later 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 does not apply to grandparents or others.
Tax savings strategies for education are explained in IRS Publication 970, Tax Benefits for Education (Jan. 31, 2018, http://bit.ly/2CBXnfc).
A parent can add a child to his health insurance plan. In most cases, this requires 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.
If a parent has health coverage at work, the plan administrator, HR department, or other person in charge of this employee benefit should be notified. If a parent’s plan only covers themself, a change of plan will be required to cover the child. If a parent has family coverage, the new child should be added to the plan.
If a parent has coverage through a government marketplace, having or adopting a baby is treated as a “life event,” for which a special 60-day enrollment period applies. During this period, a taxpayer can begin or change coverage. The coverage is retroactive to the date of the event.
If a parent bought coverage from an insurer, the insurer should be contacted regarding policy options, the time limits for making a change, and requirements for making a change.
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 (tax law places a dollar limit on tax-free assistance).
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 that supersede federal law (http://bit.ly/2HCJZLp). In a few states (California, New Jersey, Rhode Island, and, starting January 1, 2018, New York), paid family leave time is funded by employees’ payroll tax contributions.
A parent with life insurance policies, annuity contracts, retirement plans, 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, policy-holders should check with the plan’s or policy’s administrator, custodian, trustee, or other party to be sure.
Make or revise a will.
If a parent has a will that names her children, a new will should be drawn up 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, the parent may want to specifically include the child’s name. The same applies to grandparents and other relatives who want to make provisions for a new child.
Checklist for New Parents
___Did I get a copy of the birth certificate?
___Did I apply for an SSN (or other taxpayer identification number)?
___Did I set up a 529 plan or Coverdell ESA?
___Did I check on leave time from work?
___Have I added my newborn to my health insurance plan?
___Have I checked with HR to learn about related company benefits?
___Have I reviewed by withholding and estimated taxes?
___Have I changed beneficiary designations where needed?
___Have I reviewed my will?
___Do I want to set up a trust for my new child?
A parent may also want to name a guardian for a child in the will; this is the person who will 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.
A wealthy parent or grandparent may wish to set up a trust for the child, either during the creator’s life or to take effect at the time of the creator’s death.
Life’s Biggest Change
The period when a new child enters the family is usually a hectic one; routines are disrupted, and new accommodations must be made. Individuals should not ignore the importance of addressing tax, financial, and legal issues during this time, and CPA financial advisors can fill this role if they are knowledgeable and well prepared.