SAVE FIRST for the kids’ college or for your own retirement? Pundits generally recommend that parents put themselves first. But I’d argue the question demands a more nuanced answer. The tax code offers numerous tax-savings opportunities for families with dependent children—and those tax breaks shouldn’t be overlooked.
To be sure, for cash-strapped parents, the top two financial priorities should be building up an emergency fund and putting at least enough in their 401(k) or 403(b) to capture the full employer match. Already doing that? Instead of shoveling further money into retirement plans, consider whether you’d be better off exploiting these seven kid-related tax strategies:
Want flexibility? Think twice before opening a prepaid tuition plan. One friend funded a prepaid plan, but his kids later balked at all the in-state colleges covered by the plan. The go-to website to review all things 529 is SavingforCollege.com.
The downside: Coverdells have a relatively modest $2,000 per year contribution limit, plus there are income limits on who can fund these accounts. We contributed to Coverdells for just a couple of years and used the money for high school costs, so our tax savings proved quite small. Today’s 529s are almost certainly a better alternative, because all families can contribute, no matter what their income, and you’re allowed to contribute substantial sums.
While custodial accounts can generate small amounts of tax-free income each year, they come with some serious drawbacks. The money becomes the child’s, typically at age 18 or 21, and the balance counts heavily against college financial aid eligibility. Some parents don’t tell their children about any custodial accounts, while others spend the money on behalf of the child prior to college—especially if the kid is an out-of-control teen. The maximum each parent can transfer to a child without triggering the tax gift is $15,000 in 2019 and 2020.
We funded modest custodial accounts for both kids and structured the investments to provide income below the threshold where taxes kicked in. That saved our family a few hundred dollars in taxes each year. We never used the custodial accounts for college expenses. Instead, our daughter’s account became a townhouse down payment, while our son’s account continues to grow.
Which will save you more in taxes, the childcare credit or the FSA? You’ll need to crunch the numbers, given your childcare costs and tax situation. If you’re strapped for cash, funding the FSA and then later reclaiming the money might seem like a short-term financial drain. But those with higher incomes will typically fare better with an FSA—assuming it’s offered by their employer.
Your employer may also offer an FSA for health care costs, which can be a great way to pay deductibles and copays for both you and your kids. Health care FSA contributions are limited to $2,750 in 2020. Think carefully about how much to contribute, because unspent money could be lost. We maxed out our health care FSA for many years to pay for both kids’ orthodontist costs.
John Yeigh is an engineer with an MBA in finance. He retired in 2017 after 40 years in the oil industry, where he helped negotiate financial details for multi-billion-dollar international projects. His previous articles include 7,000 Days, Window Dressing and Creeping Costs.
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