April 28, 2012
You've finished this year's taxes and filed your FAFSA for aid. Looking at your tax return, the question may pop up - what happens when I can't claim my new college student? How long can I avoid that anyway? Would they be better being 'independent'? All good questions to make sure that one is both taking the best advantage of the rules and planning for life changes.
Taking the questions in reverse, classifying your student as 'independent' is difficult. In general, the classification is designed for those students that really have no other means of support. Right or wrong, the general terms to be independent are students over 24 or having some external determination, such as wards of the court or married students. I'll assume that most parents don't want to take these measures (although we may have all considered the ward of the court option at some point in the teenage years!)
Rules to claim your student as a dependent
General rules to claim a dependent start with whether you are providing at least one-half of their support. That is the first step for exemptions, but there are lots of rules and exceptions (even some people that you are supporting may not qualify!).
Specific rules for students:
Are they a student? They should be a student for at least 5 months of the year in question (the tax year).
They have to be a qualified relative. Children includes adopted, foster, step children or other descendents (grandchildren). Brothers and sisters can count as well.
Students can be claimed as children up to age 24. Those over 24 can still qualify if they have less than $3,700 of gross income and you meet all other tests.
They must have lived with you more than half the year - living at college can count as living with you
They must be classified as 'single' on their tax return.
Only one person may claim an exemption for anyone, including students. Divorce usually ends up with dependency being decided in the decree. If not, make sure both parents are in agreement on which is claiming the exemption - only one can. The other issue that trips people up is how the student files. Because only one person can claim the student. They should check the box indicating that "someone else can claim you" as an exemption and complete the worksheet. Most students will still end up with either zero taxable income or something much lower than the savings to the parent.
Planning for them to (truly) leave
I always encourage people to think ahead. When your son or daughter no longer meets the rules above, you'll be losing an exemption. It is important to think about this at the start of the year and not be caught with an unexpected bill at year end. Remember that exemptions are based on the status at the end of the year, so if your student is 25 on December 31 or otherwise doesn't meet the criteria above on that date, then they are not eligible to be a dependent for the whole year.
The easiest way to adjust for this is by changing the withholding exemptions on the Form W-4. Subtracting one from this number will likely deal with the tax implications. If you are in a situation that involves something more complex or just want to know how much the impact will be, take the current exemption ($3,800 for 2012) times your marginal tax rate. That is the rate at the highest tax bracket you are in. Your tax software usually gives you this on a summary page or you can refer to the federal tax tables.
It also never hurts to check the options. It may be that the exemption could work either way. Maybe your student just finished school and started a job. They still meet the criteria above (24 or under at 12/31, lived with you more than half of the year and a student for five months) but now they have a job and want the most tax savings. In these days of tax software it is possible to calculate both returns with and without the exemption and see which combination works best.
The example would be that the parent may save $1,140 by claiming the exemption where the impact to the child's return is only $570 (30% tax bracket vs. a 15% bracket). That is a total savings of almost $600! I'll leave it up to you how to settle it.
Dependents and Exemptions http://www.irs.gov/publications/p501/ar02.html#en_US_2011_publink1000220868
Philip Laube is a CPA in Ohio and the Assistant Vice President for Business & Finance at Muskingum University. He presents and writes about personal finance issues for college students. He can be followed at twitter and on his web site