Five reasons for parents to celebrate: introducing new tax benefits for kids

Review of Business, Wntr, 2002 by Mary D. Maury, Irene McCarthy

The 2001 Tax Act (a.k.a., H.R.1836: The Economic Growth and Tax Relief Reconciliation Act of 2001) provides substantial tax relief with five new types of benefits specifically targeted to children. Ranging from tax credits to adoption programs to child-care assistance, these tax advantages are explained and explored in this article.

Introduction

Over the next 10 years, there will be substantial changes in tax laws as they relate to children, thanks to some key provisions of the tax bill that became law in May 2001. The Economic Growth and Tax Relief Reconciliation Act of 2001, Title 11 (or, as well call it, "the 2001 Tax Act") has five sections that should spell relief for taxpayers with dependents:

Sec. 201: Modifications to Child Tax Credit

Sec. 202: Expansion of Adoption Credit and Adoption Assistance Programs

Sec. 203: Refunds Disregarded in the Administration of Federal Programs and Federally Assisted Programs

Sec. 204: Dependent Care Credit

Sec. 205: Allowance of Credit for Employer Expenses for Child-Care Assistance

Like all other facets of the new law, these provisions will expire over time, unless they are renewed or made permanent before 2011. In the meantime, it would behoove taxpayers to familiarize themselves with the new law and even ask a couple of questions. For example...How and when will families be impacted by the changes? Will everyone benefit?

This article will examine these issues -- and much more -- in an attempt to compare tax treatments currently available to families with the effect the new provisions could have on a family's tax liability.

Learning the 'ABCs' of Tax Terms

Let's begin by defining some of the terms we'll use in this article:

* A tax credit is a dollar-for-dollar reduction of taxes owed. This differs from a "deduction," which only reduces taxable income. There are several tax credits available to different people for different reasons. These include: the earned income credit, child and dependent care credit, credits for the elderly and the disabled, education credit and foreign tax credit. To enjoy any of these tax credits, you have to be eligible -- i.e., be in the group for which the credit was designed -- and you often have to have adjusted gross income (AGL) that falls within certain, defined limits. Each credit carries its own set of rules for eligibility.

Tax credits can reduce the taxes you owe all the way down to zero. Generally, if the credit is more t than the tax you owe, the excess cannot be refunded to you, unless specifically allowed. However, some credits -- like the one for mortgage interest -- can be carried forward for three years if they are not fully used up in the current calendar year.

* Tax liability is the total amount of tax owed based on your income less your applicable deductions and exemptions. This liability is reduced by any tax credits for which you ire eligible, as well as any payroll tax deductions or estimated taxes you have already paid.

* Earned Income includes wages, salaries, tips, professional fees and other compensation you've received for performing personal services. It does not include your pension, annuities, Social Security payments, Worker's Compensation, interest; dividends or unemployment compensation.

* Adjusted Gross Income (AGI) includes all taxable income minus certain adjustments, such as Individual Retirement Account (IRA) deductions, moving expenses and alimony.

* Phase-Out in tax law refers to a gradual reduction. Benefits can be phased out when modified AGI reaches certain amounts built into the tax law (as with education credits). These phase-outs often work on a sliding scale -- the higher the income, the greater the reduction in credits.

The new tax law phases out the overall limitation on itemized deductions and exemptions. The limitations will be reduced by one-third in tax years beginning in 2006 and 2007, and by two-thirds in tax years starting in 2008 and 2009. The overall limitation will be eliminated for taxable years beginning after December 31, 2009.

* Phase-In in tax law refers to a gradual change. For example, the new tax law begins different changes at different times -- thereby "phasing in" these changes.

* Alternative Minimum Tax (AMT) is an additional tax that certain people have to pay. The tax law gives special treatment to certain kinds of income -- making it nontaxable -- as well as allowing special deductions and credits for certain kinds of expenses. AMT was created to ensure that taxpayers who benefit from these special treatments will still have to pay a minimum amount of tax. Figuring the amount of AMT owed is a complicated calculation requiring a recalculation of taxable income by adjusting some items and recomputing others. In the year 2000, if your recomputed taxable income was $45,000 and you filed your tax return as either married filing jointly or qualifying widow(er) with dependent child, you were likely to be subject to the AMT.

How the 2001 Tax Act Makes Parenting Less 'Taxing'

The rest of this article will explore, in some detail, the five major changes in the 2001 Tax Act as they relate to benefits for children.