Four Tax and Benefit Planning Thoughts for New Parents
"A good plan implemented today is better than a perfect plan implemented tomorrow."
― George Patton
“Someone's sitting in the shade today because someone planted a tree a long time ago."
― Warren Buffet
With my newborn daughter just a few months into her life, I’ve been walking through the maze of new parenthood. We're changing diapers, sleeping strange hours, and adjusting to new relationships with our partners, our friends, and family. If you’re in the same boat, the last thing on your radar might be the tax and employee benefits decisions set before you. Whether you already have a couple kids, or are expecting your first, here are a few things for you to consider.
Free things first. You don’t have to do (almost) anything to get the following tax break. You, your spouse, and each dependent receive a personal exemption each year. In 2016, the exemption is $4,050 per individual. If your marginal tax rate is 33%, you will pay $1,336.50 less in federal income taxes. If someone else is preparing your income tax return, be sure to notify them of your child's birth. They'll also need the child's social security number for your return. Happily, this exemption is not prorated for the year. If your child is born on December 31st at 11:59pm, you still qualify for the entire exemption! But personal exemptions do phase out as your income rises. For married couples this phase-out begins at $311,300 this year.
In the first month of life your child is probably covered under your health care plan. But what you absolutely cannot forget is that within that first month you must register them and establish their own health account. If you neglect to do this, you could have to wait until your company’s open enrollment period. If one person is planning on taking extended time off work, or is unsure of when he or she will go back to work, then it probably makes sense to add your baby to the other's plan. Both partners should check with their HR to see what the cost of adding an additional person to their plan is. The difference in cost and benefits could be significant between employers. Happily, you can do all this research before baby arrives.
You can coordinate the addition of your child by contacting your Human Resources department and following their instructions. They will probably ask for an official record of birth, which the Hospital will give you upon discharge. Once your child is issued a social security number (this takes a few weeks), you will have to call it in and add it to the child’s records. Remember the three steps: get the birth record, call HR and fill out their paperwork, and finally make sure to follow up with the social security number when you receive it.
When my wife had our baby I asked my dentist if he recommended dental insurance for the baby. He counseled that it's not necessary in the first year, but in the first 18 months it may be a good idea for your kid to have their first appointment so they can get used to the environment. Letting them experience a dental office early on will allow them to start with a positive experience.
Child and Dependent Care Credit
The Child and Dependent Tax Credit allows couples to deduct some of the expenses associated with childcare that allow them to work. Depending on your income level, this will either be 20 or 30% of expenses up to the maximum of $3,000 for one child, or $6,000 for two. The maximum credit is $1,800 (that is, 30% of $6,000.) If you pay for care for a dependent parent/grandparent or disabled individual, their expenses may also qualify for the credit. While 20% of $3,000 is no fortune, it would be a shame to miss out on it every year. Nannies, daycare, after school, and preschool programs are examples of eligible expenses, while K-12 and overnight summer camps are not. To earn this credit both spouses must either work or be students, and the qualifying child must be under the age of 13. The IRS also stipulates, "You must identify all persons or organizations that provide care for your child or dependent. You must report the name, address, and taxpayer identification number (either the social security number or the employer identification number) of the care provider on your return." Your tax planner will be happy to share with you specific advice around your expenses and which ones might qualify.
Since we’re on the topic - if you don’t already know the difference between a tax credit and a tax deduction, it’s worth your while to think about it for a moment. Tax credits are great. They reduce your tax bill dollar for dollar. Deductions on the other hand will adjust your gross income before calculating tax. So if you have a credit for $1,000 it will reduce your tax total by $1,000. A tax deduction of $1,000 will reduce your gross income by $1,000. If you are in the 33% marginal tax bracket, this deduction will lower your bill by $333.
Dependent Care FSA
With October, and open enrollment season in full swing, now is a great time to consider Dependent Care Flexible Spending Accounts. Dependent Care FSAs are a benefit that is set up with an outside plan administrator by your employer, allowing you to deduct pre-tax dollars to pay for dependent care while you are at work. The IRS doesn’t give out a lot of free lunches, but FSAs are as close as it gets. And unlike Health Care FSA’s, which require you to have a high deductible health insurance plan, all you need for the Dependent Care FSA is an eligible dependent, eligible expenses, and a plan with your employer.
A Dependent Care FSA is of special value to high income earners because a) it doesn’t phase out as you reach upper tax brackets and b) the higher the tax bracket you are in, the more you are saving since you pay a higher tax rate.
The annual $5,000 limit is per family, for partners filing jointly. To use the maximum deduction amount you must each have at least $2,500 of earned income. But you can use just one partner’s FSA to deduct the entire $5,000. This could be helpful if one of you works at a large company which offers an FSA, while another works at a start-up or small business which does not. FSA’s pro-rate your annual FSA deduction according to each pay period.
When you sign up for the FSA account you will be able to choose how much you would like to deduct. If you'd each like the full annual limit of $2,500 taken out over 12 months you'll deduct $208.33 a month. But you'll notice that your total paycheck won't go down by that amount, since you've been taxed on that pay up to this point. The difference will be what you are now saving in taxes from using the FSA.
Transferring your deducted funds to your child care provider may include the following two options:
Pay the provider- Some plans will allow you to arrange for direct payments to your child's provider. You may be able to set this up online via your plan administrator's portal.
Reimbursement- FSA administrators will have you deliver receipts for qualifying payments you have already made. You may be able to set up for direct deposit or they'll mail you a check.
Dodging FSA Pitfalls
It is important to avoid a couple pitfalls.
FSA money doesn't roll over each year. What you don't spend, you lose. So be safe, estimate your likely expenses on the lower side, and use up your FSA amount well before the end of the year. Also, if you leave your employer, funds already deducted into your FSA generally stay with the company. So spend them before you give notice.
Signing up for the Dependent Care is normally only available for sign-up during open enrollment, or during what the IRS deems as a "qualifying life event" (like having a baby). If you have a kid in January and plan on having childcare from August through December, contact HR and coordinate the FSA account set-up in that first month after birth. If you have a kid in June, but don't plan on going back to work until January of next year, you should also set up the FSA during open enrollment so that you coordinate the tax free use of funds when you return to work at the beginning of the upcoming year.
Putting It All Together
The personal exemptions and tax credit should be taken care of by your tax preparer when they complete your return as long as you notify them of the birth, your kid's social security number, and the required information for the Child and Dependent Care Tax Credit. It is possible to take advantage of the Child and Dependent Tax Credit as well as use a Dependent Care FSA. You just can't double dip for the same expenses. As an example, say you have $10,000 of eligible expenses for your 1-year old and both you and your spouse work. $5,000 of expenses will qualify for the FSA, while another $3,000 will qualify for the credit.
By taking care of your child's health benefits, taking advantage of the personal exemption and tax credit, and setting up an FSA you will have graduated to the next level of financially responsible parenthood. You might also be considering how to best save for your child's future life and education expenses. What are the options? Does a taxable brokerage account, a Roth IRA or a 529 savings plan make sense? What are the rules around each? We will begin to explore these in the next post.
If you’d like to dive a little deeper, spend time with the IRS directives on child and dependent care credit. I’ve also found that many FSA administrators have great websites. Salesforce, and many companies in the Bay Area use Wageworks, which has a particularly easy to use informative site.