Federal Exemptions: Reduce Your Taxes One Dependant at a Time

Jan 15, 2010

The Bottom Line Federal exemptions can help reduce taxable income, so claim then whenever you can.

A new year brings with it several new things. Many people create a list of family goals for the year. Others strive to eliminate debt or increase savings. Still others make resolutions that, as hard as they try, are not likely to be kept. Regardless of what you do on a personal level, there is one thing you must do and cannot avoid: Filing and paying your federal taxes. W-2 forms will be arriving soon and most of us, while we will certainly dread the task ahead of us, will make the best of a bad situation by looking for as many ways as possible to reduce our tax burden.

Several methods exist for cutting your taxable income down to size, but one of the most frequently used is Federal exemptions. Even if you don't plan on itemizing deductions, you are still entitled to reduce your taxable income through the use of exemptions.

What are Exemptions?:

Exemptions come in two types: personal exemptions, and exemptions for dependents. Personal exemptions include those taken for yourself, and for your spouse, if you are married. Everyone is entitled to take a personal exemption unless he/she can be claimed as a dependent on someone else's tax return.

If you have dependant children, whether they are your own children by birth, adopted, stepchildren, etc., they will usually qualify as an exemption provided they are a dependant. To qualify, he/she must meet the following:

Member of Household: The individual must have lived with you for at least half of the year and cannot have provided over half of his/her own financial support.  

Citizen or Resident: The individual must be a U.S. citizen, U.S. resident alien, or U.S. national (or a resident of Canada or Mexico) for at least a part of the tax year that you are filing your return.

Joint Return: The dependent cannot file a joint return. The only exception to this would be in the case of a dependent who files a joint return, along with his/her spouse, simply as a claim for a tax refund when in fact there would be no actual tax liability for either individual (dependent or spouse) if he/she filed a separate return.

Gross Income: The dependent cannot have gross income over $3,650 in 2009 unless he/she is under 19 years of age or a student under age 24 at the end of the year.

Financial Support: The dependent must be receiving more than half of his/her financial support from you for the past year. There are two exceptions to this rule. One exception would be if there are two or more people providing support, but no one person is providing half of the support (for example, if a student earned $3000 for the year, and received $2000 in support each from two different people, then no one person has provided half of the total support of $7,000). Another exception would be if the person receiving support is the child of divorced or separated parents.

Remember that the dependent must meet all five of the above conditions, to qualify as an exemption. Other relatives can also qualify as an exemption provided they meet certain criteria, such as income below the $3,650 threshold, living with you (meaning, the person attempting to claim as an exemption) for the full year, etc. Also, a child who is permanently or fully disabled qualifies as a dependant regardless of age.

How Much are Exemptions Worth?:

For the 2009 tax year, each exemption that you claim will reduce your taxable income by $3,650. You need to keep in mind that this is a reduction in taxable income, not a $3,650 reduction in your tax liability (in other words, not a tax credit of 3,650). You simply take your number of qualified exemptions, multiply by 3,650, and reduce your taxable income by the total amount. If you are married filing a joint return and have one child, for example, then your total exemptions would be 3, multiplied by $3,650, equals $10,950 in taxable income reduction.

Do Exemptions Have Much Impact on Taxes?:

Since exemptions reduce your taxable income, they have the greatest impact (if you base it solely on actual dollars saved) on those who are in higher tax brackets. If an individual is in a 36 percent tax bracket, for example, then each exemption will reduce his/her tax liability by $1,314 (.36 times 3,650). If an individual is in a 15 percent federal tax bracket, then each exemption will reduce the tax liability by only $435 (.15 times $3,650). The greater your tax rate, the more each exemption will save you in taxes.

Even though the actual tax dollars saved per exemption is less for those in lower tax brackets, the relative savings (in percentage terms) is greater for those at lower income levels, and that's why exemptions tend to be most beneficial to those who earn less. For example, let's say that you are in the 15 percent tax bracket, and your taxable income (before exemptions) is $12,000. This would make your tax liability for the year $1,800. But if you had three exemptions, your taxable income would be reduced to only $1,050 ($12,000 less $10,950 in exemptions) and this would lower your tax liability to only $157.50. That's a savings of 91.25 percent in tax, and this money that could really come in handy for a lower- income individual. For an individual in a higher bracket, the total dollars saved with three exemptions would be greater, but when stated in percentage terms, it would be much less than 91.25 percent.

For those with very high adjusted gross income, personal exemptions actually phase themselves out once a specific level of income is reached. For 2009, each exemption is reduced by two percent for every $2,500 that the adjusted gross income exceeds a defined level. The phase- out income threshold for 2009 is $250,200 AGI for married filing jointly; $208,500 for Head of Household; $166,800 for single filers; and $125,100 for married filing separately.

Final Thoughts:

Federal exemptions are the taxpayer's first- line of defense. They represent a deduction in taxable income to which every tax payer is entitled. Even those with high adjusted gross incomes can still claim exemptions. They might not be worth as much as the $3,650 standard, due to the phase- out provision, but they will likely still be worth something.

With federal tax exemptions, dependants can generally be included in your write- offs provided they meet the official criteria for dependency. Relatives can also be exempted if they meet official criteria. An individual can only be exempted once, however, so the taxpayer needs to make certain that no other tax return includes the same social security number as the individual he/she is trying to claim as a dependant. If any tax return has already claimed someone as an exemption and you attempt to do the same, you will get a letter and possibly a phone call from the Internal Revenue Service, stating that you cannot claim the same individual because they have already been claimed. Your tax return will be adjusted accordingly. This is a common problem with children of divorced parents. Often, each parent will try to claim the child. Only one is entitled, and it usually comes down to a court decision that decides which parent can make the claim.

Tax exemptions do not provide a very large reduction in federal tax, but they certainly can make a difference in your tax liability. They reduce your taxable income, and hence, your Federal tax liability. Exemptions can greatly benefit those who have a large number of dependents. Sometimes, if taxable gross is low enough already, the additional federal exemption reduction from having a large number of dependents can possibly be enough to reduce the individual's tax liability to zero. Just keep in mind, however, that federal exemptions are a taxable income deduction- NOT a tax credit. The money you save in taxes will be equal to the exemptions you claim multiplied by your marginal federal tax rate.  

Try to claim as many exemptions as you possibly can, making sure to stay within the legal boundaries defined by the IRS. Even if your tax liability is reduced by only a small amount, it's still better than nothing. The IRS won't be hurting, so try to take advantage of all the tax- reducing options that are available, and reclaim some of your hard- earned income.  

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