Tax season is rapidly approaching, and taxpayers across the nation will soon look for any tax breaks they can find. Claiming dependent exemptions is a smart way to reduce your taxable income, because for each exemption, you get a $4,050 reduction on the 2016 tax return you'll file early in 2017. But there are sometimes complicated rules you have to follow in order to claim dependents properly. Below, we'll look at those rules and how you can make the most of the favorable tax provisions governing dependents.
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Who counts as a dependent?
The tax laws divide dependents into two categories: qualifying children and qualifying relatives. A qualifying child must be related to you, although the permitted relationships are broader than just your children. Under the rules, siblings, nieces and nephews, and grandchildren are also among those who are potentially eligible to be your dependent. Children must be U.S. citizens or residents who are younger than 19, or younger than 24 if they're full-time students. Children with permanent and total disabilities have no age limit. In addition, the child typically must live with you for more than half the year, you must provide at least half of the child's support, and you must be the only person claiming the child as a dependent. Finally, the child must not file a joint tax return with a spouse.
By contrast, the qualifying relative rules are broader in some ways and narrower in others. No age limit applies, and eligible relatives include parents, grandparents, and other more extended family relationships than what's covered under the qualifying child rules. Unrelated household members can also qualify, although they must live with you year-round, which isn't required for most relatives. To be a dependent, the person must have income of less than $4,050 in 2016 for you to claim an exemption. The person must still be a U.S. citizen or resident, and you must provide more than half of the person's financial support for the year.
Should you claim a dependent?
In most cases, it makes sense for taxpayers to claim dependents if they meet the legal tests. That's because dependents typically have minimal income and therefore pay less in tax than those providing support, and so the tax break is worth more to the person providing support.
However, that isn't always the case. For example, take a 23-year-old married child who is in school and whose spouse has a substantial income from work. The parents of the child might be able to claim the child as a dependent if they met the relevant tests for support. However, doing so would prevent the child from filing a joint return, and that could result in much higher tax liability for the child's spouse on a separate return. It might save the whole family more if the parents gave up the dependent exemption and let the child file jointly with the child's spouse.
How dependent exemptions can go away
The $4,050 reduction in taxable income per dependent can reduce your tax by hundreds or even thousands of dollars. However, some taxpayers don't get to take the full exemption amount. Specifically, the dependent exemption provision phases out for taxpayers who have adjusted gross income above a certain level. The table below lists the phaseouts for various filing statuses.
Data source: IRS.
For every $2,500 you make above that amount -- or $1,250 for those who are married filing separately -- you lose 2% of your total exemption for dependents. That means that once you're $125,000 above the threshold, you won't get to take any exemption at all. High-income taxpayers therefore get essentially no benefit from claiming dependents on their taxes.
Handling divorce situations
Last, keep in mind that if you're divorced and have children, there will be some hoops to jump through in order to make the dependent exemptions work out the way you've agreed to. Typically, the custodial parent is the one who gets to claim dependent exemptions on children. However, the IRS allows divorced parents to treat children as dependents of the noncustodial parent if the custodial parent signs a special form, IRS Form 8332. The noncustodial parent must then attach that form to the tax return for the year.
In general, it makes sense to claim as many dependents as you're entitled to claim. By knowing the rules, however, you can plan your taxes in a way that will produce the greatest savings -- regardless of how many dependents you decide to claim.
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