Having just finished one of these, I searched our database and noted that we had written very little about it.
In my case earlier this week, my adversary and I had been negotiating a child support order. After several rounds, we reached a mutually acceptable conclusion. When I wrote to confirm our “terms” I received a responsive email that the child’s father wanted to claim the child as a dependent on his federal income tax returns “every other year.” My client would justly ask: What does that concession mean and what is it worth?”
If you do your own income taxes at the federal level, you know that on page 1 of the return you are asked to name your “dependents” and on page 2 you can claim a deduction reducing your taxable income by $4,000 for every eligible dependent including yourself. So if Mr. and Mrs. Hubbard are living in the same shoe and they have two minor children, they can take a total of $16,000 in exemptions (i.e. deductions) from their income ($4,000 x 4). But what happens when Father Hubbard splits to live with another storybook character? Clearly, if the Hubbard’s continue to file joint returns, nothing much changes. But Father Hubbard is now paying some deductible alimony to Mother and he needs to file separately in order to claim it. And since he is paying child support as well why can’t he deduct at least one of the kids?
Well the Internal Revenue Service is on this and since 1984 they have taken the position that the deduction associated with a child goes to that parent who had primary physical custody.
The parties can agree to split the deductions (one parent takes each child) but absent an agreement, the deduction stays with the parent who has the kid most of the overnights, even though the non-custodial parent may be paying most or all of the freight. More recently as we have seen increases in shared physical (50/50) custody, the service has held that the deduction in that instance goes to the parent with the larger adjusted gross income. See our blog on this 11/1/12.
As we have noted, the deduction can be traded and the IRS has a Form called No. 8332 that allows parents to do that. So what is the deduction worth? $4,000 right? Well, not so fast.
The real value of the deduction depends on your taxable income for single folks with taxable income under $10,000; the deduction is only worth 10% of the face amount or $400. But for a head of household with taxable income over $50,000 it is worth 25% or $1,000. Get that taxable income up into the $200,000 range and the deduction accelerates to 33% or $1,320. The value of the deduction tops out at 39.6% or $1,584 but your taxable income has to top $400,000 to get that amount. Beware that as adjusted gross income (AGI) starts to exceed $150,000 the IRS begins to nibble away at the value of the exemption through a “phase out.” For many high income taxpayers, there is effectively no personal exemption to deduct because of the phase out.
One other thing to know. Assigning the exemption to another does not affect a taxpayer’s right to be a head of household and to use those slightly lower tables in determining the actual tax due. But one thing is clear; while dependency exemptions do reduce your taxes, they do not do so dollar for dollar. An exemption is, at best worth the equivalent of $110 per month and, at worst worth about $35 monthly.
N.B. IRS Publication 504 is the best place for a layperson to consult on line. Every one of the rules described above has a plethora of exceptions.
A Friendly Amendment To Our Blog On Dependency Exemptions:
I heard from one reader with a very apt point. As income rises, into levels above $150,000, the dependency exemption does phase out and there is a level where it disappears completely. So I was incorrect to suggest that it has a minimal value. It can be zero and you certainly don’t want to get into a fight over “nothing.”