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| The Basics | How many exemptions can you take?
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Yes, your kids and relatives depend on you. But what's that worth at tax time? Here's how to figure out a confusing point of tax law.
By Jeff Schnepper
It looks so easy on the tax form, but it's one of the most common mistakes that people make each year. We're talking about "exemptions," and who legally qualifies for these very valuable tax deductions.
You get an exemption for yourself, your spouse and, potentially, for all your dependents. This is what confuses everyone: you can have a dependent who doesn't qualify as an exemption.
An exemption gives you a major tax deduction. On your 2005 taxes, you get a deduction of $3,200 for each exemption you claim. (The amount rises to $3,300 in 2006.) You automatically get yourself and your spouse, but the rules are a bit different for dependents.
To qualify as a dependent, a member of your household must pass the following four tests. To qualify as an exemption, he or she must then pass a fifth test. But there are advantages to qualifying as a dependent that we'll discuss later, even if you don't meet the additional test to qualify as an exemption.
The member-of-household or relation test
To meet this test, a person must live with you as a member of your household for the entire year, or be a listed relative. Listed relatives include biological, adopted or stepchildren, siblings, half or stepsiblings, your ancestors, stepparents, aunts, uncles, nieces, nephews and in-laws; sorry, no cousins or foster parents.
Even those who don't qualify as relatives can qualify as members of your household, but they must live with you all year.
A child born during the year can still qualify as a dependent. So can someone who dies mid-year.
The Citizenship Test
To meet this test, the person must be a U.S. citizen or resident, or a resident of Canada or Mexico.
The Joint-Return Test
Normally, you can't claim a person as a dependent if he or she files a joint return. But this test doesn't apply if the joint return is filed merely to claim a refund and no tax liability exists for either spouse on separate returns.
For example, if your daughter files a joint return with her husband and each of them has earned $4,000, neither would have to pay a tax. If they file to get a refund of any withholdings, that doesn't disqualify them under this test.
The Support Test
You have to provide more than half the person's total support for the calendar year. You can even pay support with borrowed money. Support is what's spent, not what's earned. If you have a child who won a million-dollar lottery and all that money was invested, you've still provided 100% of that child's support.
What you save with a dependent
If you meet all of the above tests, you have a dependent. Let's look at what that entitles you to claim . . .
If someone qualifies as your dependent, you're allowed to deduct all his or her medical expenses -- if you pay them. So you deduct all your kid's checkups, doctor visits, vaccines, etc.
If an aged parent qualified as a dependent, you can also deduct all his or her medical expenses, including any expenses in a nursing home. Here's where good planning can save substantial dollars.
If you have parents in a nursing home, they probably aren't earning big dollars, and the deduction for their medical costs won't save them much. However, if they gift the dollars to you (tax-free) and you write the checks, the deductions belong to you. Not only have you reduced your parents' estates for Medicaid qualification in the future, but also now you can qualify for substantial tax savings.
If they're in a nursing home for medical reasons, all of the payments qualify as medical expenses. If you're paying $5,000 per month each, that's a $120,000 medical deduction that goes on your return.
Now, let's qualify them for the exemption. To get that deduction, they must pass a fifth test . . .
The Gross-Income Test
Gross income includes all income in the form of money, property and services. Tax-exempt income and Social Security don't count for this test. If you're totally and permanently disabled, money received for services rendered at a sheltered workshop also doesn't count.
To pass the gross income test, your dependent can't have gross income of $3,200 or more for 2005 -- or $3,300 in 2006. If you fail this test, the person may still be a dependent, but you won't get the exemption deduction.
But this is tax law, and for every rule, there's typically an exception. This test doesn't apply if the person is your child and is either under 19 or a student under age 24. A "child" includes adopted and stepchildren, as well as a foster child who qualifies as a member of your household.
If the child is under 19, it doesn't matter how much money that child makes. You still have to pass the support test, but that's what's spent, not what's earned.
To qualify as a student, you have to go to school some part of five months during the year. If you've been in school since January, you meet the "student" classification even if you graduate in May.
Passing this test gives you the $3,200 exemption deduction in 2005 and $3,300 exemption in 2006. But the amount you can deduct is phased out once your adjusted gross income (AGI) goes above a certain level.
You reduce the dollar amount of your exemptions by 2% for each $2,500 or part of $2,500 ($1,250 if you're married filing separately) that your AGI exceeds the following amounts for 2005 and 2006. You can't claim an exemption if your income exceeds the amount in the Phase-out ends column.
| When the personal exemption phases out in 2005 | | 2005 AGI Level ($) | Phase-out starts | Phase-out ends | | Married filing jointly | $218,950 | $341,450 | | Married filing separately | $109,475 | $170,725 | | Single | $145,950 | $268,450 | | Head of household | $182,450 | $304,950 |
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| When the personal exemption phases out in 2006 | | 2005 AGI Level ($) | Phase-out starts | Phase-out ends | | Married filing jointly | $225,750 | $348,250 | | Married filing separately | $112,875 | $174,125 | | Single | $150,500 | $273,000 | | Head of household | $188,150 | $310,650 |
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