Understandably, many parents get in the habit of claiming their children as dependents on their federal tax returns. You generally may do so as long as your child is either under age 19 (nonstudents) or under age 24 (students). But there is a reason to not claim your child as a dependent — and it has everything to do with higher education.
Credits and phaseouts
The two primary college-funding tax credits available are the American Opportunity credit and the Lifetime Learning credit. Thanks to recently passed legislation, the American Opportunity credit now permanently allows eligible taxpayers to take an annual credit of up to $2,500 for the first four years of postsecondary education. Meanwhile, the Lifetime Learning credit provides up to $2,000 in relief to those eligible. (You can’t claim both credits in the same year for the same student.)
But these credits are subject to “phaseouts” that limit eligibility for higher-income taxpayers. For example, for 2015, eligibility for the American Opportunity credit begins to phase out for taxpayers with modified adjusted gross incomes (MAGIs) beyond $80,000 (single filers) or $160,000 (married couples filing jointly). Similarly, eligibility for the Lifetime Learning Credit begins to phase out for taxpayers with MAGIs beyond $55,000 (singles) or $110,000 (joint filers).
If your income disqualifies you from claiming these credits, your child’s income probably doesn’t disqualify him or her. Therefore, your child may be able to report payment of education expenses for tax purposes and then claim one of the credits — but only if you don’t claim him or her as a dependent.
Under this scenario, the child’s tax benefit typically outweighs the value of the dependency exemption to the parents. Why? First, a credit reduces taxes dollar-for-dollar, while an exemption reduces only the amount of taxable income. Second, an income-based phaseout may reduce or eliminate the benefit of the exemption even if you did claim your child as a dependent. For 2015, the phaseout starting points for the exemption are adjusted gross incomes of $258,250 (singles) and $309,900 (joint filers).
The right call
If your dependency exemption is phased out, it will probably make sense not to claim your child as a dependent so he or she can grab a tax credit. But if your exemption isn’t phased out or is only partially phased out, the decision becomes trickier. We can help you make the right call.