With the proper paperwork supporting that she paid Kim a fair wage for work actually performed, Dr. Duncan can deduct her daughter’s wages, $7,500, on her taxes. Assuming she’s in a 35% tax bracket, she saves $2,625 in income tax. Kim, meanwhile, offsets her $7,500 in earned income with the $5,800 standard deduction, leaving only $1,700 in taxable income. Since Kim is in a 10% tax bracket, she owes $170 in taxes and the family saves nearly $2,500—which can be put in a fund for future college costs.
Cedric M. Bright, a physician in Durham, North Carolina, says that employing a child might be a great idea to help cope with rising college costs. Dr. Bright and his wife, Maria, have a 4-year-old son, Andrew. When Andrew enters college 14 years from now, they can expect to pay about $260,000 for a four-year private college education. “We expect him to go to college,” says Dr. Bright, “and the costs then might be twice what they are today. It might be the case that a bright youngster will be able to do valuable work for a parent.”
Putting a youngster on the payroll may force parents to pay Social Security, Medicare, and unemployment taxes, reducing the ultimate tax benefit, if their business is structured as an S or C corporation. However, says Genevia Gee Fulbright, a CPA in Durham, “some parents may get tax breaks if they run sole proprietorships or partnerships in which each partner is a parent of the child. If they employ their dependent children under age 18, those wages are not subject to Social Security, Medicare, or federal and in some instances state unemployment taxes.”
Both the American Opportunity and Lifetime Learning credits are available through 2012 to offset college costs. You can’t use both for the same child, though. Of the two, the American Opportunity tax credit offers the better deal, tax savings of up to $2,500 per student. To save $2,500, you must spend at least $4,000 on tuition, fees, books, supplies, and equipment.
Other conditions apply. To take advantage of the American Opportunity tax credit, you must pay expenses for a student in the first four years of post-high school education who is pursuing an undergraduate degree and going to school at least half time. To get the full $2,500 tax credit, your income cannot exceed $80,000 for single taxpayers or $160,000 for those who file joint returns. The credit phases out with incomes up to $90,000 (single) or $180,000 (joint).
“For those who qualify,” says Fulbright, “the American Opportunity tax credit is up to 40% refundable.” Thus, if you claim a tax credit of up to $2,500 and the credit is greater than your tax liability (even if your liability is zero), the difference is refundable to you, up to 40% of the credit you’re claiming, which is $1,000 if you claim the full $2,500.