Child-Care Tax Credit May Change
QUESTION: I don’t understand how President Reagan’s proposed change in the child-care tax credit would affect me. Is this part of his tax reform proposal perceived to be a negative or a positive for working parents?--W. R.
ANSWER: The proposed change to a tax deduction from the current tax credit generally would hurt families at the lower end of the income scale and benefit higher-income families.
Currently, if your adjusted gross income is $10,000 or less, you are entitled to reduce your tax bill by an amount equal to 30% of your allowable child-care expenses. For every $2,000 of adjusted gross income over $10,000, your allowable tax credit declines by 1 percentage point, down to the 20% credit allowed for taxpayers with adjusted gross incomes over $28,000.
What are allowable child-care expenses in the eyes of the IRS? The money you spend for someone to care for your children so you can work, up to a yearly maximum of $2,400 for one child or $4,800 if you pay someone to care for two or more of your children.
President Reagan wants to replace the credit--which directly reduces your taxes--with a tax deduction--which reduces your taxable income--while retaining the annual expense limits of $2,400 or $4,800.
What difference would that make? If you pay someone $2,000 a year to take care of your only child, you would save between $400 and $600 a year in taxes, depending on your income level. Importantly, the more you make under the current system, the lower the credit that you are allowed.
Under the President’s proposed system of three tax brackets, you would save $300 in taxes if you are in the 15% bracket, $500 in the 25% bracket and $700 in the 35% bracket.
As you can see, lower-income taxpayers would pay more taxes (all else being equal) under the President’s plan while higher-income taxpayers would fare better. In this example, taxpayers at the lowest level would see their tax savings dwindle to $300 from the current $600.
At the other extreme, taxpayers in our example currently allowed a $400 credit would get as much as $700 in tax relief under the President’s proposal.
Q: I have started my IRA early this year and have come across what sounds like a great deal. A bank I know and trust is offering a rate that is 6 percentage points higher than the typical IRA account at the other financial institutions I’ve checked. The only catch I have been able to uncover is that I have to open and contribute to a regular savings account at the bank in order to get the higher rate. I know the account pays a considerably lower rate of interest than I could get by putting my money elsewhere, but when I weigh everything, it still sounds very attractive--especially because it will be covered by deposit insurance. I know you always advise that, when a return on investments sounds too good to be true, it is. But can you spot any obvious problems with this one?--M. S.
A: What you are talking about is a so-called Super IRA. This is a device that some financial institutions have used to attract new business--to the consternation of the IRS. And therein lies the catch.
The IRS has warned financial institutions that it takes a dim view of the devices and has threatened to disqualify these types of IRAs as tax-deferred retirement savings plans.
It also has ruled in the case of one taxpayer that the earnings resulting from the inflated rates must be treated as taxable income and that taxpayers will be penalized because the “phony” interest breaks the laws on so-called excess contributions to an IRA.
So, if you take the extra 6 percentage points, the IRS position is that the interest you earn on your IRA contribution as a result of those extra points is immediately taxable as ordinary income. Further, the agency has said it would slap a 6% penalty on this extra interest because in theory you contributed more to your IRA plan than allowed. And if you had received any of this money, you could be subject to a stiffer 10% penalty.
In other words, you might sleep better if you kept shopping around.
