04/05/2012 10:17 am ET Updated Jun 05, 2012

Financial Impact of Adoption

It's hard to think of any act more generous than adopting a child. Not only are you bettering the life of a child in need, but many adoptive parents I know also tell me it's the most personally rewarding thing they've ever done.

But adoption is not cheap. Adoption-related expenses can quickly mount to tens of thousands of dollars. And sadly, sometimes adoptions do fall through, forcing prospective parents to endure the process -- and expense -- all over again.

Fortunately, the IRS provides significant tax incentives for people who adopt. For example, you can claim the adoption tax credit, which directly lowers the amount of federal income tax you owe. And, if your employer provides an adoption assistance program, you can also exclude from your taxable income any expenses they paid on your behalf. Some states also provide tax credits or other benefits for adoption.

Anyone considering or in the midst of an adoption should know that several IRS policies and dollar limits for adoption tax credits and exclusions have changed for 2012.

Adoption tax credit. Depending on your income level, you may be able to claim a non-refundable tax credit for up to $12,650 for qualified expenses paid to adopt an eligible child. This amount decreased from $13,360 in 2011. A few adoption credit rules and definitions:
  • The adoption credit is per child; thus the amount doubles if you adopt two children in the same year.
  • For your adoption expenses to be eligible, the child must be under age 18 or physically or mentally unable to care for him or herself (see "Special needs adoptions" below).
  • You must provide the IRS with a copy of the adoption decree.
  • "Non-refundable" means you can claim a credit for only up to the tax amount you owe.
  • "Qualified adoption expenses" include adoption fees, court costs, attorney fees and travel expenses (including meals and lodging while away from home). See IRS Form 8839 for details. (Note: Costs related to surrogate parenting or adopting your spouse's child are not eligible.)
  • If your filing status is single or married filing jointly and your modified adjusted gross income (MAGI) is $189,710 to $229,710, the credit amount you can claim gradually reduces; over $229,710, you cannot claim any credit. (If your filing status is married filing separately, you can claim the credit only if you meet certain special requirements.) The Instructions for Form 8839 contains an MAGI calculation worksheet.
  • Note: The IRS has not yet posted a 2012 version of Form 8839, so check for any rule changes before filing your 2012 taxes.

Special needs adoptions. Families who adopt special needs children are entitled to claim the full $12,650 credit, even if their out-of-pocket expenses were less than that amount. "Special needs children" are those the state determines cannot or should not be returned to their parent's home and who probably won't be adopted unless assistance is provided. This group may include older children, siblings, children with disabilities and those currently in foster care. In addition to the adoption decree, you'll also need to provide a copy of the child's adoption assistance agreement or a letter from the state showing that the child has special needs.

When to claim your credit. If the child is a U.S. citizen or resident alien, the following rules apply for both successful and failed adoptions:
  • For expenses paid before the adoption is final, take the credit on the following year's tax return.
  • For expenses paid in the year the adoption is finalized, take the credit on that year's return.
  • For expenses paid in the year after finalization, take the credit in the year paid.
  • Because it's nonrefundable, if the credit due to you exceeds a given year's tax liability, you may carry any remaining credit forward for up to five years, until you've used it up.
Foreign adoptions. If the child you adopt is a foreign national, you may only claim the tax credit or exclude employer-paid benefits after the adoption has become final. In addition, if the adoption is ultimately unsuccessful, you cannot collect the credit for those expenses.

Employer adoption assistance. In addition to the tax credit, you also may be able to exclude from your gross income for tax purposes any employer-paid amounts under a qualified adoption assistance program, whether paid to you or a third party. You cannot, however, claim both a credit and an exclusion for the same expense.

With domestic adoptions, you must take the exclusion in the year in which the expenses were paid. However, with foreign adoptions, until they are finalized, you must claim the employer amount as income in the year it was paid; then when the adoption becomes final, you may make take the exclusion on that year's return.

Future adoption tax benefits. Adoption tax credit rules have become increasingly less generous in the last few years. For example, in 2010 and 2011, the credit amount was higher and was refundable -- i.e., you could get a refund for amounts over your tax liability.

For now, unless Congress extends the 2012 limits, the maximum tax credit amount will revert in 2013 to the original $5,000 cap ($6,000 for a special need child). No word yet on what the maximum income phase-out range will be after 2012.

Adoption should not be entered lightly. Make sure you're working with an attorney and/or adoption agency well-versed in current adoption law. Several helpful sites can help guide you through the process, including the government's Child Welfare Information Gateway (which features a state-by-state adoption resources search engine), the Department of Health and Human Services' and the North American Council on Adoptable Children. Also review the IRS's Adoption Benefits FAQs.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

To participate in a free, online Financial Literacy and Education Summit on April 23, 2012, go to Practical Money Skills.