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Help You Support Your Aging Parents

Take Advantage of Generous Tax Breaks

As baby boomers age, so do their parents. In many cases, middle-aged children will help support parents or other elderly loved ones - and those costs can be extensive.

Opportunity: Tax credits and deductions help reduce the effective cost of supporting your parents. Also, making some minor adjustments in spending patterns or behavioral habits, such as switching investment and savings accounts, can bring you major tax savings.

Key: Some of the rules relating to supporting parents have recently changed with the Working Families Tax Relief Act of 2004.

Dependency exemptions

One possible tax break is being able to claim one or both of your parents as dependents.

Each dependency exemption you can claim provides a $3,200 deduction in 2005, up from $3,100 in 2004.

Limits: This break may not mean much for upper-income taxpayers. In 2005, couples filing jointly start losing the benefit of dependency exemptions (and deductions) when their income exceeds $218,950. They get no benefit at all if their income tops $341,450.

Required: Even if you are generally eligible for the dependency exemption, certain tests must be met for a parent to be a "qualifying relative," as defined under the new law:

• Income. Your parent's income can't exceed the dependency exemption amount, which is $3,200 in 2005.

This amount refers to the taxable amount. For low-income parents, Social Security benefits aren't taxable, so this won't be a problem.

Tax-exempt interest doesn't count, either, so you might want to switch your parent's bank accounts, taxable bonds, and bond funds to tax-exempt bonds or funds.

• Support. You must provide more than half of a parent's support during the year.

Key: If your parent lives with you, put a fair market rental value on the housing you provide, as well as food, medicine, transportation, etc., that you pay for.

If your parent does not live with you, money you pay toward rent or housing costs can be included in support along with other expenses, such as those mentioned above. Optional items - clothing, entertainment, etc. - also can be included.

Strategy: Keep track of this calculation throughout the year and make sure you wind up paying at least 51%. Urge your parent to defer year-end spending of personal funds if it's a close call.

• Other tests. In addition to meeting the above income and support tests, a dependent must be a US citizen or a resident of North America. He/she can't file a joint tax return, unless the return is filed only to receive a refund for taxes paid.

The person must be a relative (parent, stepparent, parent-in-law, grandparent, great-grandparent, aunt, uncle) or a full-time member of your household.

Multiple support agreements

If you have siblings, it's only natural that you share the burden of supporting, say, your widowed mother. In such situations, it's possible that all siblings together provide more than 50% of the parent's support, but no one sibling does alone.

Strategy: You and your siblings can agree to file Form 2120, Multiple Support Declaration, with your tax return.

Required: Each signer must contribute at least 10% of the parent's support for the year, and the total must exceed 50%.

The siblings can agree that one brother or sister will take the dependency exemption in a given year. For example, have the sibling who provides two-thirds of the support claim the exemption in two years out of three.

Wrinkle: A high-income sibling should not be included in the rotation because he will get little or no tax benefit, as explained earlier.

Note: Starting in 2006, the deduction cutback for high-income taxpayers described on page seven will start to be phased out. The cutback will disappear entirely in 2010.

Dependent care credit

If you pay someone to care for your parent so you can work, you might be eligible for a dependent care tax credit. As much as $3,000 that you spend for such care is eligible for the credit.

What it's worth: Assuming your family income is more than $43,000, the credit rate is 20% (lower incomes get a credit rate as high as 35%).

What's covered: Home care as well as fees paid to an elder care day care center.

Example: You and your spouse both work and your joint income is more than $43,000. You spend more than $3,000 to have someone care for your widowed mother during the day.

Your tax credit would be worth $600 (20% of $3,000). If you hire someone to care for two people, that 20% credit can be applied to $6,000 in expenses, for $1,200 in tax savings.

New rules: Beginning in 2005, you can claim this credit even if you don't meet the 50%-plus support test. However, the qualifying relative must live with you for more than half the year.

Opportunity: Some employers offer a flexible savings account (FSA) that covers dependent care. Up to $5,000 can be contributed to the FSA and used for dependent care expenses, tax free.

If you're in such a plan and your parents are included as qualifying dependents, you probably will be better off using the FSA and forgoing the dependent care tax credit. If you use $5,000 in an FSA and you're caring for one parent, you can't also claim the $3,000-per-person credit. If you're caring for two parents, spending at least $6,000, use $5,000 from the FSA, then you can figure the credit on $1,000 worth of expenses.

Medical costs

If you pay some or all of an elderly relative's medical bills, they might be deductible as long as the relative is a dependent.

Loophole: Even if you can't claim a relative as a dependent, you still may be able to deduct medical payments made for that person. You need to be able to meet all the dependency tests except for the $3,200 income limit, mentioned earlier.

Adding medical bills paid for a parent may put you over the 7.5%-of-income requirement for medical deductions.

Example: Your income this year is $100,000, so you need to spend more than $7,500 on medical expenses to deduct any of them. However, the total of your own unreimbursed medical outlays is only $4,000, so no deduction would be allowed. (Your unreimbursed medical outlays equal the amount you would normally claim on your tax return, without counting outlays for a parent.)

Suppose you provide more than 50% of your widowed mother's support, including $10,000 you spend on her medical bills. That brings your total to $14,000, allowing you a $6,500 medical deduction ($14,000 - $7,500).

Don't forget to include any premiums you pay for a parent's Medigap or long-term-care insurance.

If you and your siblings file a multiple support declaration, the sibling that claims the exemption should pay all the medical expenses for that year. The other siblings can pay different expenses to even out the total support costs for a given year.

That will maximize deductible medical expenses for the year. The other siblings relinquish parent-related tax benefits for the year so any medical bills they pay won't be deductible.

Trap: Money you spend on dependent care also may qualify as a medical expense, but you can't take both the credit and the deduction for the same outlays.

Strategy: Do the math both ways to see which provides the greatest tax benefit. If you're able to deduct medical expenses and you're in a 25% tax bracket or higher, that's a better deal. If you can't take medical deductions because you're below the threshold, or if your tax bracket is 15%, you're better off with the 20% credit.

Head of household status

If you're not married and you help to support a parent, you may claim head of household filing status. The requirements here are less stringent than those for claiming a parent as a dependent.

Benefit: You'll owe less than you would as a single filer.

Required: To qualify, you must provide more than half of your parent's housing costs or nursing home costs. Alternatively, your parent can live with you for more than half the year.

Various other tax rules are much more favorable for head of household filers than for singles, so this can be a valuable tax break.