Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part I. The Foundation
Chapter 4. Dependents and Filing Status
Backstage Directors in Your Individual Tax Formula
A chess board and a checkers board are identical. Both are made up of 64 tessellated squares that alternate between two colors. You can use the same board for either game. Other than the similarity of the game board, however, the two games are very different. They are governed by different rules that control how the pieces move and where they can go. While the rules of the game are usually unseen during play, their existence is continuously felt and the entire outcome of the game is based on them.
In a tax return a similar scenario exists. There are two components of the return that act as an ever-present influence over the remaining rules that govern the tax formula. The first component is the determination of who qualifies as a “dependent” of a taxpayer. The second governing component is for what filing status a taxpayer qualifies. These two determinations will exert their influence throughout the tax formula, much like the rules of a game or an unseen director managing a play from behind the curtain. They have a significant and continuous effect on the final outcome of the tax return, determining the deductions, credits, exemptions, taxable income, and tax tables that you will use for your return.
Whether you can claim an individual as a dependent on your tax return has a far-reaching effect on the amount of tax you will pay. The qualification of a dependent can change your deductions and credits. It will determine the number of exemptions that you can claim. It can even affect the filing status that you claim. There is no portion of the tax return (other than income) that is not influenced by the claiming of a dependent.
For the most part, whether or not you can claim a person as a dependent is determined by the rules that govern the dependency exemption. Even when considering a deduction or a credit, whether or not a person qualifies as a dependent will be based on the exemption rules. For that reason we will focus on the dependency exemption.
As a reminder, exemptions are a specific amount of income that is exempt (or free) from tax. This dollar amount changes every year, based on inflation. The exemption is subtracted from a taxpayer’s income, in addition to other deductions, in order to arrive at “taxable income.”
Each taxpayer is generally allowed one exemption for him- or herself (assuming the taxpayer is not another person’s dependent), one for his or her spouse (if married), and an additional exemption for each person who qualifies as his or her dependent. As an example, if a married couple has one dependent child they would be allowed to claim three exemptions (one for each spouse and one more for the child). If the exemption amount for a particular year were $4,000, that couple would be allowed to claim $12,000 in exemptions (3 exemptions x $4,000 per exemption = $12,000). Thus, $12,000 of their income would be free of tax.
Beginning in 2013, the dependency exemption phase-out rules have been revived from a decade earlier. Under the phase-out, the total amount of exemptions that a taxpayer can claim is reduced once his or her taxable income reaches a certain level.
Once a person’s taxable income has crossed the applicable threshold, that individual’s exemptions are reduced by 2% for every $2,500 (or portion thereof) that the income exceeds the threshold. This means that in a year where the exemption is worth $4,000, $80 is subtracted ($4,000 x 2% = $80) for each exemption for which a person otherwise qualifies, for every $2,500 by which their income exceeds the threshold. In fact, if that individual’s income is $122,501 (or more) above the threshold, the exemptions are completely eliminated.
Example Trisha and Stan claim five exemptions on their tax return—one for each of them, two for their children, and one more for Trisha’s father, who lives with them. In a year in which exemptions were valued at $4,000, ordinarily these five exemptions would allow them to claim $20,000 less taxable income ($4,000 per exemption x 5 exemptions = $20,000). However, Trisha and Stan have $380,000 in taxable income, which is above the threshold and thus triggers the phase-out of their exemptions. As a married couple filing jointly, their threshold is $300,000, which puts them $80,000 over in taxable income. That $80,000 reduces their exemptions by 64% ($80,000 ÷ $2,500 increments = 32 increments over the threshold. Each increment reduces the exemption by 2%, so 32 increments x 2% = 64%), or $12,800 (64% x $20,000 of exemptions = $12,800). Because of this they can only claim $7,200 in exemptions ($20,000 – $12,480 = $7,200).
It is also worth noting that this method of reducing exemptions is very disproportionate in its consequences for various circumstances. For example, if the exemption dollar amount for a given year were $4,000, the phase-out would trigger an $80 reduction for each exemption for every $2,500 that taxable income exceeded the threshold. For an individual claiming one exemption, $2,500 of additional income would reduce the exemption by $80. But a taxpayer with five exemptions would suffer a $400 reduction in exemptions for the same $2,500 of increased income ($80 per exemption x 5 exemptions). Because of this, the taxpayer with more dependents to care for is the one hit with a significantly larger increase in tax!
The exemption dollar amount for 2014 is $3,950 per exemption. The thresholds that trigger these exemption phase-outs are shown in Table 4-1. The income levels at which the exemptions are completely eliminated are shown in Table 4-2.
Table 4-1. Taxable Income Thresholds Which Trigger Phase-outs for 2014
Table 4-2. Taxable Income Levels at Which Exemptions Are Eliminated for 2014
Qualifying as a Dependent
There are three classifications of individuals who can qualify as a dependent, each with its own set of rules. The three classifications are:
· Qualifying Child
· Qualifying Relative
· Qualifying Non-Relative
In order to be a Qualifying Child, the individual must meet the following requirements:
· The child must be a close relative (son, daughter, stepson/daughter, brother, sister, stepbrother/sister, or a descendent of any of those individuals). Children who are adopted, placed with the taxpayer for adoption, or placed with the taxpayer as a foster child meet this test for qualification.
· The child must meet an age limit test (must be younger than the taxpayer, younger age 19—or 24 if a full-time student—or be totally and permanently disabled).
· The child must meet residency and filing status requirements [must have the same principal residence more than half of the year and not file a joint return (unless solely to claim a refund—meaning zero tax liability)].
· The child must not have provided for more than half of his or her own support. (The taxpayer need not have provided half of the child’s support.)
Note A child born any time during the year qualifies as having lived with the taxpayer during the entire year, even if born on December 31st.
In order to be a Qualifying Relative, the individual must meet the following requirements:
· The individual must be a relative (children, grandchildren, stepchildren, parents, grandparents, brothers, sisters, aunts, uncles, nieces, nephews, and in-laws). (Foster parents and cousins fall under the non-relative rules.)
· The taxpayer must have provided for more than half of the person’s support. Support means providing for the actual expenses incurred for the individual. (If no one person has contributed more the 50% of the support, a group of taxpayers who together have provided more than 50% can decide which person can claim the exemption. An example of this might be three children combining to equally cover the living expenses of an aged parent.)
· The person being claimed as a dependent must not have an annual gross income greater than the exemption amount for that particular tax year. Tax-free income is not included in the calculation (scholarships, tax-exempt interest, and possibly Social Security).
· The person must be a U.S. citizen, or a resident of the United States, Canada, or Mexico.
· The person being claimed must not file a joint return (unless solely to claim a refund—meaning zero tax liability).
Note In the case of a divorced couple, the parent who has actual custody of a child for more than half of the year will generally be the one to claim the exemption. This is determined by the amount of time that the parent has the child, not by the divorce decree. It does not matter whether the parent provided more than half of the child’s support. If the parents have exactly equal custody, the parent with the higher AGI will receive the exemption.
In order to be a Qualifying Non-Relative, the individual must meet all of the requirements for a Qualifying Relative, except:
· The person must live with the taxpayer for the entire year, not just 50%. (In addition, the taxpayer’s relationship with the dependent must not violate local law.)
If a person qualifies as your dependent, it will be a great benefit to you in the final result of the taxes you will owe. If you have a person who is not clearly a dependent, but could possibly be one, it is worth spending the time to understand what rules need to be met so that he or she qualifies.
While the declaration of your filing status is a simple check-box at the beginning of your tax return, it has far-reaching effects into several key parts of the tax formula. Your filing status governs the limits of eligibility for many above-the-line deductions and credits. It determines the point at which Social Security income is taxed. Your filing status also determines the dollar value of the Standard Deduction that you are allowed to claim. Finally, your filing status also determines which set of tax brackets (or tables) you are subject to, which in turn determines your tax, and can dramatically affect the amount of tax you will owe.
There are four sets of tax tables. Two of these tables apply to married individuals and two apply (generally) to singles. The main reason for the differences in filing status is to reduce the penalty that would be assessed on a married couple for combining their income, and to attempt to reflect the reality of combined expenses with that combined income.
Example Cynthia and Robert each earn $45,000 per year in their respective jobs. As unmarried individuals, this income (minus the standard deduction and exemption) would place them in the 15% marginal tax bracket. However, if Cynthia and Robert married each other and there were not in an alternate tax bracket, their combined income of $90,000 would subject a significant portion of their income to the 25% tax bracket. The various tax brackets that relate to differing filing statuses are an effort to minimize such a discriminating penalty against a couple who is married over one who is not. (However, the marriage penalty still exists in many instances—just not to the degree that it would if there were not separate filing statuses.)
Each of the four tables corresponds to a particular filing status. There is one additional filing status that is intended to ease the transition from married to single for those whose spouse has died but who still care for a dependent. This final filing status allows a single widow(er) to use the tax tables of married couples for two years.
The filing status that you select will have an effect on several parts of your tax formula. It will determine how much you can claim for various deductions and credits, as well as your effective tax rate. While each one of the five statuses is governed by strict rules that you must meet in order to claim a particular status, it is good to understand those rules and the implications of each status, because if you meet the qualifications of more than one filing status, you may choose which one to use. The following is a list of the five filing status options:
· Single (S)
· Married Filing Jointly (MFJ)
· Married Filing Separately (MFS)
· Head of Household (HofH)
· Qualifying Widow(er) with dependent child (QW)
Your marital status is determined on the last day of the year. Even if you get married on December 31st, you are considered married for the entire year for tax purposes. The same is true if a divorce becomes final on the last day of the year—the individuals are considered single for the entire year. The following is an explanation of the qualifications that determine which filing status applies to you:
· Single (S)—This is the default status, meaning that if none of the other statuses apply to you, you must file as single. Conversely, you cannot file as single if you are married. This status generally applies to you if you have never been married or if you are legally separated or divorced (and not married to someone else) on the last day of the year. However, some singles will qualify for the better tax brackets that belong to the Head of Household or Qualifying Widow(er) statuses, described below.
· Married Filing Jointly (MFJ)—If you are married on the last day of the year you must either file jointly or separately. Filing jointly means that the tax return takes all of the income and deductions of a couple and combines them together as if it were all from one individual instead of from two (you are allowed to file jointly even if only one spouse has income). Joint filing also means that both spouses are fully responsible for the taxes owed on the return, no matter which spouse’s income or withholdings led to the liability. You may not claim this status if you are legally separated or have received a final divorce decree.
· Married Filing Separately (MFS)—This is the other option for those who are married. It is very rare that filing MFS would result in paying fewer taxes. Lawmakers have gone to great lengths to ensure that people do not file separately for the sole purpose of thwarting the tax code and reducing their taxes. To this end, the tax brackets and phase-outs associated with MFS are fairly punitive.
Under most circumstances, the only time it is better to file separately is if one spouse believes that the other is not being honest with his or her tax return or if one spouse owes a lot of money that the IRS is trying to collect and the other is due a refund. In addition, it may also be a good choice to use the MFS status if spouses are truly separated. On rare occasions the MFS status can result in lower taxes for a couple, so to be safe you could try running the numbers both ways, but it will take significantly longer to do (and cost more if you use a tax preparer), with little chance of a better result.
· Head of Household (HofH)—The Head of Household status will result in lower taxes for those individuals who qualify to claim it because it grants a higher standard deduction and has more generous tax brackets associated with it than those that are available to the Single and MFS statuses. In order to qualify a person must be single, legally separated, or be married but living apart from his or her spouse during the last six months of the tax year. The individual must also maintain a home that is the principal residence for more than half of the year for one of the following:
· A dependent son or daughter (legally adopted children, stepchildren, and descendants all qualify as a son or daughter). This filing status applies even if the individual has waived his or her right to the child’s dependency exemption.
· The individual’s father or mother. (In this case only, the parent does not have to live with the individual, so long as the individual maintains a home (contributing over half the cost of upkeep) for the parent (including a nursing home).
· A dependent relative (must live with the taxpayer). This includes parents, grandparents, brothers, sisters, aunts, uncles, nephews, nieces, stepparents, and parents-in-law (but does not include cousins, foster parents, or unrelated dependents).
· Qualified Widow (Surviving Spouse) with Dependent (QW)—This is a special filing status that is granted to those who would have qualified as married had the spouse not passed away. In the year that the spouse dies the widow(er) is allowed to file MFJ, even though he or she is not technically married on the last day of the year. Then, for the following two years the surviving spouse is allowed to claim the QW status (as long as he or she does not remarry), which essentially grants the same standard deduction and tax tables as those used by MFJ couples.
In order to qualify for the QW status, though, the surviving spouse must also maintain a household that is the principal residence for a dependent son, daughter or stepchild by blood or adoption (and qualify to claim the exemption for that child).
Use the Rules to Your Advantage
When the game board is placed before you, a choice to play chess or checkers must be made. When a significant amount of your money is on the line, you would be wise to choose the game whose rules favor your skills the best. Once you choose the game, the rules govern from that point forward.
In this same way, once a filing status is chosen and dependents are determined, the rules governing these components will take over and govern everything else that happens in your personal tax return. It would be wise to understand the implications of those rules, in order to put yourself in the best possible position for the game.