Say your parents or in-laws are semiretired and still earning a bit of income, but you're helping them financially. They also watch your young children while you and your spouse work.
You probably can't claim a dependency exemption for your parents because their income surpasses a certain level.
But here's a way to reap a sweet tax break in that situation: Pay your parents or in-laws for baby-sitting instead of providing outright financial support. That way, you can claim the dependent care credit (commonly called the "child care credit") for your payments. The credit is a dollar-for-dollar reduction of your tax bill, not just a deduction.
You salvage a tax break from this situation and probably fare better with the tax credit than claiming a dependency exemption for your parents.
The tax law says you can claim the child care credit for money spent caring for your under-age-13 kids while you're at work. The credit amounts to 30 percent of the first $3,000 of qualified expenses for one child; $6,000 for two or more children.
The credit percentage gradually reduces as your income increases. It bottoms out at 20 percent for taxpayers with adjusted gross income (AGI) above $43,000.
The credit isn't limited to just day care centers. You can claim it for care provided by a relative if you don't claim that relative as your dependent.
Example: Paying Mom directly
Say your widowed mother earns only $5,000 a year from her investments. You and your spouse pay the $750 monthly rent on her apartment. Returning the favor, she watches your two kids, ages 7 and 3, so you both can work. You're in the
28 percent tax bracket.
In that situation, you can't claim your mother as your dependent, even though you provide more than half her annual support. She earns more than the dependency exemption amount ($3,100 for 2004).
But you can still cut your tax bill simply by shifting the way you support your mom.
How? Pay your mother by check—instead of paying her landlord—and indicate the payments are for child care services.
That allows you to claim the child care credit for the money paid to Mom. Since your adjusted gross income exceeds the $43,000 ceiling, you're entitled to a $1,200 tax credit (20 percent of the first $6,000 of expenses).
In comparison: Say your mother's income fell below the threshold, so you took the $3,100 dependency exemption. The dependency exemption is worth only $868 to you in your 28 percent tax bracket (28 percent x $3,100).
Bottom line: You can reap more tax savings via the child care route (a $1,200 tax credit) versus a dependency exemption worth $868.