Laura Rowley Money & Happiness

Kids are a blessing in so many ways -- especially at tax time. The government offers an array of deductions, credits, and incentives to help parents raise and educate their children.

The Basics

The most basic is the child tax credit for dependents under age 17. It cuts your bill by $1,000 dollars per child for the 2006 tax year. But the credit begins phasing out at higher incomes: $110,000 dollars for couples who file jointly; $75,000 for single heads of households; and $55,000 if you're married but filing separately.

For parents who are adopting, the government offers a dollar-for-dollar tax credit of more than $10,960 to help cover expenses such as court costs, adoption and attorney fees, and travel expenses. But the credit phases out at incomes above $164,410, and there are limitations (i.e., adopting your spouse's child does not qualify).

Parents are eligible for the credit in the tax year after they finalize the adoption. (For more information, see IRS Form 8839.)

Help with Child-Care Payments

You may be surprised to learn that Uncle Sam will help pay for child care for kids under age 13, including a nanny, nursery school, kindergarten, or even summer camp. The Child and Dependent Care tax credit can cover from 20 percent to 35 percent of your costs, up to $3,000 for one child and $6,000 for two or more children, depending on household income, according to Elda Di Re, a partner with Ernst & Young.

Eligible taxpayers include households with:

• Two parents working full-time

• A working single parent

• One parent earning an income while the other is a full-time student or is disabled and unable to care for the children

The credit doesn't completely phase-out at higher incomes. "There's a misconception among people that once you make a certain amount of money you won't get the credit, but that's not true," says Di Re. (For more information, see IRS Publication 503.)

The Feds Get Flexible

Meanwhile, working parents whose employers offer flexible spending accounts for dependent care have a significant tax advantage.

With these plans, a parent commits before the beginning of the year to have their employer withdraw up to $5,000 from their pre-tax pay, and set it aside for child care. Parents then submit receipts for dependent care expenses to their company administrator, who pays the bills from the monies set aside.

Because that income is never taxed, someone in the 40 percent tax bracket would pay just 60 percent of the cost of their child's care. So, if your three- or four-year-old's preschool tuition is $5,000 per year, and you're in the 40 percent tax bracket, your actual tuition cost will be just $3,000.

As an added bonus, you'll have reduced your taxable income by $5,000. One drawback: If you don't use the money in your flexible spending account during the calendar year, you lose it.

Keep in mind that you can't double dip on both programs. "If you're going to choose the Child and Dependent Care Credit or the flexible spending account, the latter is usually a better tax deal," says Di Re. "But if you're doing your tax return and you didn't do a spending account last year, then go ahead and claim the credit."

Teenage Tax Tips

If you have a teenager who earned income in 2006 -- through a summer job, say -- consider opening a Roth IRA in her name, Di Re suggests. "Although you don't get a tax deduction for the Roth contribution, it grows forever tax-free," she explains.

Di Re recommends opening a Roth over establishing a UGMA (Uniform Gift to Minors Act) custodial account. "The Roth is a great way to set up lifetime savings for a child."

Although Roth IRAs are designed to be retirement vehicles, a child could use the money later in life for other expenses, because the contributions (but not the profits) can be withdrawn at any time with no tax or penalty. (In some circumstances -- such as a home down payment -- the profits can be withdrawn penalty-free as well, although tax must be paid if the money is withdrawn before age 59-1/2.)

Tax Savings and College

As for college savings, the biggest tax advantages come from state qualified tuition plans, or 529 plans. As of the third quarter of 2006, more than 9 million children were enrolled in 529 plans, which held more than $97 billion, according to information clearinghouse College Savings Plans Network.

Investors can save money in a child's name, or pre-pay tuition at a specific university. Money in these accounts grows tax-deferred and is free of federal taxes when withdrawn.

Consumers can choose plans outside their home states, and the plans typically offer a variety of investments, including an age-based portfolio that shifts from aggressive to more conservative as a child nears college age.

"One of the benefits is that a 529 is not going to be throwing off income each year as a child is growing up," says CPA Joe Hurley, founder and CEO of Savingforcollege.com. "If you're investing in other vehicles, and the child earns more than $850 in investment returns, you're going to run into the kiddie tax. The cost and hassle of filing a child's tax return is something people don't think about when putting money in a kid's name."

529 Plan Essentials

Because the 529 account is owned in a parent's name, it has minimal effect on financial aid eligibility. (President Bush's current budget proposal would exclude 529s entirely from consideration in financial aid, but Hurley doubts the provision will survive.)

Individuals can contribute up to $12,000 a year without triggering the federal gift tax (as long as there are no other gifts during the year). The plans also allow a lump-sum contribution of $60,000 per donor if no other contributions are made in a five-year period. Most plans have a lifetime maximum contribution of $250,000 to $300,000.

Meanwhile, 31 states and Washington, D.C., sweeten the 529 deal with an upfront tax savings. The deductions vary widely -- from unlimited deductions in four states (New Mexico, Colorado, West Virginia, and South Carolina) to a paltry $250 deduction offered by the state of Maine (and that's with income limits).

As an example, my husband and I kept our 529 plans in New York even after we moved out of state, because he still commutes to Manhattan and we get hit with state and city taxes. New York's 529 plan allows investors to deduct the first $5,000 of their contribution from state taxes each year ($10,000 for married couples filing jointly).

Be Smart about Deductions

But don't pick a plan based on the tax deduction alone, says Hurley. "The upfront tax deduction is a big reason to consider your own state's 529 first -- but it doesn't make it a no-brainer to use your state's 529 plan."

Hurley continues, "The value of the deduction varies based on the age of the child. If your child is older and you're going to use the money soon, it's hard to beat the tax deduction with investment returns. But if your child is young, even a small increase in investment returns over time will outweigh the value of the deduction."

Once a child is in college, there are a variety of education credits to help pay for tuition, including the Hope Scholarship and Lifetime Learning Tax Credit. But you can't use both at the same time, and there are income and other limits. (For eligibility information, see IRS Publication 970.)

Many states also offer educational tax credits. "When you have kids in college, talk to an accountant to make sure you get every available deduction and credit you're eligible for," says Di Re.