Monday, May 2, 2011

How much are your kids worth on your tax return?

As Facebook would say, "It's complicated." It depends on the amount of your income, the type of your income (earned vs. unearned), your filing status, the age of your children, whether they are enrolled in daycare or college, whether they have earned and/or unearned income of their own, whether you have set up tax-favored savings accounts earmarked for their education, just to name a few factors.

Want more? It can also depend on how much you are paying for their daycare, college, or health care expenses; whether they are full-time students for at least five months of the tax year; if they are students, it can make a difference whether they are in preschool, K-12, undergraduate, or graduate school.

And wait, there's more! There are multiple different tax breaks for education and daycare expenses, but there are also some complicated "no double-dipping" rules for each of those so the value of your kid-related spending on those categories can depend on whether you are using tax credits vs. a tax-favored account to pay for those expenses. (And, of course, it's not always easy to figure out in advance which of these will be most advantageous. And, to make matters worse, there are actually some circumstances in which using a "tax-favored" flexible spending account to pay for daycare could be worse than forgoing all daycare-related tax breaks.)

And the list goes on: if you have investment income, the taxable value of your kids can depend on whether that income comes from capital gains and qualified dividends versus other types of investment income, as well as whether your circumstances have pushed your return into alternative-minimum-tax (AMT) territory. (And, believe it or not, having too many kids can indeed be the straw that pushes your tax return into AMT.)

Elaine Maag of the Tax Policy Institute captures one dimension of that complexity in this graph:

The graph above is based on a single parent of two children under age 13. The graph's construction also assumes that the only household income are the taxpayer's wages, and presumably also makes some other simplifying assumptions about the amount spent on daycare for the children, the use of the standard deduction, etc.

Even in that relatively simple and straightforward scenario, it is clear that the tax value of children has a rather incoherent roller-coaster shape.

There is a wealth of additional details in her recent article with her TPC colleagues Stephanie Rennane and C. Eugene Steuerle, A Reference Manual for Child Tax Benefits, which is highly recommended reading for anyone interested in this topic.

One very notable omission from that article, however: there is very little discussion of the fact that virtually all the tax benefits associated with children go to the custodial parent of the child.

At our VITA site, we see a number of non-custodial parents paying significant amounts of child support (NYS law has a formula based on the number of children which can be 17% to 35% of income) and yet they typically get none of the federal tax benefits associated with the children they are supporting. (In a small number of cases, the custodial parent has chosen to exercise her option to sign over a few of the tax benefits she is allowed to yield to the non-custodial parent, but this is quite rare. Some divorce agreements may require the custodial parent to sign over those tax benefits, but many VITA taxpayers have no such provisions. In some cases, they do not have the means for a formal divorce; in other cases, they have never been married to their child's other parent, so there is no possibility of a divorce decree.)

One additional wrinkle: many states, including New York State, have state income tax provisions that amplify the tax benefits shown in the graph above. For example, New York State has a "piggy-back" EIC, which can add 30% to the EIC amounts shown in the graph above. (In an especially noteworthy departure from federal rules, New York also has a special additional EIC for some non-custodial parents who make all required support payments.) In addition, New York State has a generous child care tax credit which--unlike the corresponding federal credit--is refundable, an especially valuable provision at the bottom end of the income scale.

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