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Adoption and Taxes Part II
Saturday, October 28, 2006
So in this part of our look at taxes and adoption I'm going to introduce the biggest and "bestest" of the tax benefits available for adoptive parents: The Adoption Tax Credit. It's part of Title 26, Subtitle A, Chapter 1, Subchapter A, Part IV, Subpart A, Section 23 of the U.S. Tax Code (oh good, that was easy enough).

The text of this section can be found here which is on the U.S. House of Representatives website. I'll summarize it's contents here and try to explain it simply; however, and as I will often point out, you should follow the instructions for the required form(s) to insure you are in compliance with the applicable tax laws.

-The Adoption Tax Credit (with some limitations) allows you to a tax credit up to about $10,000ish of the adoption expenses paid (the amount changes each year due to inflation, for example in 2005 it was $10,630 and for 2006 it's $10,960).

-For International Adoptions the credit is allowed in the taxable year in which the adoption becomes final, which is of course the year in which you have that big day in court. But you get to total up the expenses paid from prior years. For example, we started the adoption process in 2006 but (hopefully) we will have the adoption final in 2007 We get to total up all the expenses paid in 2006 and 2007 and then apply the credit (in 2007 of course).

-Any unused portion of the credit (with some limitations) can be carried forward for up to five years (but we'll go into the details of that later).

Tax Definitions
But first let me cover a few tax definitions that sometimes confuse people.

A Deduction is an amount that is subtracted from your taxable income which then lowers the calculation of your tax liability (again, tax liability is the overall amount of tax you are obligated to pay, don't confuse it with the money that's taken out of your paychecks which is called payroll withholding). Deductions reduce the amount of tax but only by reducing the income that is the basis of the tax liability calculation.

An Exemption is nothing more than a deduction (see above) allowed by law to reduce the amount of income.

A Credit is a dollar-for-dollar reduction in the tax liability (this is muy bueno!!!). As stated, deductions and exemptions only reduce the amount of your income that is taxable (a calculation on taxable income gives you the actual tax you owe, aka tax liability) while credits reduce the tax liability directly.

If that's still confusing let's do a quick example. Okay, let's just take a simple example using 2005 tax year information. Let's say a family has Adjusted Gross Income (AGI) of $90,000. It may sound like a lot but depending on where you live it may just be a good, but not great, AGI. In California that amount is just a little above average. Remember that AGI is basically all your income (salary, interest you earned, capital gains, etc.) minus items the IRS does not count as taxable income (things like IRAs, 401Ks, etc.).

This family also has some deductions they take (mortgage interest they paid, gifts to charity, state income tax paid, their personal exemptions, etc.) and we'll say that totals $23,000. To make it a simple example that's the only stuff we're going to consider and thus their taxable income is $67,000 (AGI minus the deductions $90,000-$23,000=$67,000). Based on that amount they would have a tax liability of $10,086 (I get this by looking up the taxable income in the IRS tax tables).

So this is the total money they owed for income tax for the year 2005. It's basically line 63 on form 1040. If you have a copy of it (and damn it you sure should, I have copies for the past 15 years) take out your last year's copy of your tax return and see what amount you had on line 63.

But let's get back to our example. Let's also assume that they had had (as practically everyone does) payroll withholding from their paychecks throughout the year. And those totaled $9,500. Since their tax liability was $10,086 and they had only paid $9,500 thru payroll withholding, they would have to write a check to the IRS on or before April 15th (good ol' tax day) for $586. But keep in mind their actual total tax paid to the government was their tax liability of $10,086.

Now let's see what happens when we get to use the Adoption Tax Credit.

If they had qualified adoption expenses in excess of $10,630 (and since international adoptions typically cost $25,000 to $40,000 odds are they did) they would be able to use the maximum amount of the Adoption Tax Credit. And doing that would lower their tax liability from $10,086 to $0 (as in Zero Dollars).

WHAT??? They wouldn't pay any taxes at all???

Yep, that means instead of sending in a check for $586 they would get a refund of what they paid in withholding $9,500.

Not only that, but since they only used $10,086 of the $10,630 credit allowed, they would get to "carryforward" the unused credit for their 2006 taxes (for them another $544 of tax credit). The AGI number (or actually it's a Modified AGI: MAGI) is very important in figuring out the amount of credit up to that $10,000ish maximum.

So next post we'll look into the forms you need to attach to your return as well as some specifics of the limitations including MAGI. Stay tuned.
posted by Steveg @ 11:20 AM  
  • At 5:38 PM, Blogger mother said…

    It is certainly good to be able to subtract some of the expenses of the adoption as I know it gets expensive. I didn't realize you were such a financial wizard!
    Hugs, Mother

  • At 5:50 PM, Blogger Irshlas said…

    I appreciate your explantion of the tax credit. It's very helpful to those of us not so up-to-speed in the tax world. I do, however, have to add my two cents that for some of us, this "credit" is virtually worthless. As someone who grossed around $30K last year in a really poor Southern state, with a really high tax rate during the year, I never owe anything to the feds. I always end up w/ a check (albeit a TINY one). So, in the end, the tax credit doesn't do anything for me. Or does it? (perhaps you can shed some light!) It seems to me that it helps the middle to upper class with adoption expenses. It doesn't do anything to help the lower class who might want to adopt.

  • At 10:17 AM, Blogger Steveg said…


    Don't confuse the amount you owe (or get back) on your tax return and your "Tax Liability". That amount (line 63 on form 1040) is the total amount of Income Tax you owe for the tax year.

    Often most of that amount is ALREADY paid to the government throughout the year from payroll deductions known as "withholding".

    Actually this credit helps the poor and middle class far more than the wealthy. Most wealthy are excluded from using it.

  • At 11:15 AM, Blogger Irshlas said…

    Steve -
    Thanks for taking the time to answer me back. So here's another take on my situation. When I do my taxes, my tax liability for the year is always $0. This is before I even consider any other credits, including the adoption credit. So, wouldn't that mean that the credit for me is just a wash? Or am I getting bad tax advice? I have always used one of the software programs to do my taxes to take out the guesswork.

  • At 8:15 AM, Blogger Steveg said…

    Well you can carryforward the credit for up to five years until you do have situations where your tax liability is benefited from the credit.

    However the fact that you don't pay any taxes doesn't exactly mean the credit is bad and doesn't help the people who need it most, it just means your deductions and the like have already reduced your liability to $0 (which is not a bad thing).

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I'm Steve and this is my wife Stefanie. This is our story, mostly seen through my eyes, of the journey to create our family by adopting a child from Russia.

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