Parents generally believe that the longer they can claim their children as dependents, the more tax savings they will accrue. This is a misleading fallacy for most high-income families. The reality is that most parents with more than $200,000 of annual income get zero tax benefit from their children and may continue to get limited or no tax benefit under either the new House or Senate tax plans. Sorry, parents. There are two primary causes of this under the current tax regime: alternative minimum tax (AMT) and the personal exemption phase-outs (PEP).
Alternative Minimum Tax (AMT): Under the alternative minimum tax (AMT) system, there are no personal exemption deductions. A married couple can claim 0 children as dependents or 10 children but their tax under AMT is the same. Moreover, most married couples with income between $200,000 and $500,000 are likely to fall into the trap of alternative minimum tax (AMT) and, resultantly, obtain no benefit from these traditional federal tax savings. The income range of this AMT trap widens for families in high income tax states (e.g. New York, California, North Carolina), families with high value real estate, families with large miscellaneous itemized deductions, and families with several children.
Personal Exemption Phase-outs (PEP) – The American Taxpayer Relief Act of 2012 included a provision to phase-out the personal exemptions for high income taxpayers. As a result, even high income taxpayers who miss AMT end up getting zero benefit from dependent exemptions. In 2018, married couples filing jointly with more than $320,000 begin to see the exemption phase-out and the exemption is completely phased out at over $442,500 for a married couple.
If the tax law changes in 2018 as seems possible right now, there is still limited or no advantage to having dependent children for high income families. Both the House and Senate tax plans are similar in this part of the design – the elimination of personal exemptions. There is a Child Tax Credit and a Family Flexibility Credit in the new tax plans. The House version entirely phases out the credits for married couples with adjusted gross income of more than $230,000. Alternatively, the Senate version provides a child tax credit for families with income up to $580,000 but the credit would only be available to children aged 17 and under.
So having established that claiming children aged 18 and older as dependents is of little or no benefit for most families with income exceeding $200,000, when might it be beneficial for parents to let their children file their own taxes? We provided one clear opportunity here for parents seeking to reduce college or graduate school educational expenses for a child. Not claiming a child between 18-26 years old as a dependent can also be useful when purchasing health insurance under the Affordable Care Act (ACA) as we explain below.
Importantly, the ACA requires that parents provide health insurance for their dependent children. However, if a child is an adult but not a dependent on the parent’s tax return, that child need not be covered for health insurance by the parents and has the option to apply for his/her own coverage. This becomes advantageous for children in college or graduate school and for children who may be out of college, under age 26, and with limited income sources as described below.
When is this valuable?
- You buy your own private health insurance, not through an employer; and
- You make too much money to qualify for ACA tax credits on your own; and
- Your child, who is at least 18 years old and under age 26, also does not have access to a “minimum essential coverage” plan, either through a school or employer.
How is this valuable?
- You’re getting no tax benefit from this child for reasons described above.
- Adding the child to your insurance policy would increase the premiums by a few hundred dollars each month.
- If your child buys health insurance on his/her own and you plan properly, he/she can qualify for a significant (and refundable) tax credit and end up with basically free health insurance.
How can this work?
- In order to qualify for the tax credits, your child needs to apply for his/her own coverage via www.healthcare.gov.
- Your child also needs to have income that falls within a range of $12,060 and $48,240 (in most of the 48 contiguous states).
- To the extent that your child falls short of the $12,060 lower income threshold, you can gift appreciated assets and have your child sell the investments to realize a gain which becomes income for ACA qualification purposes.
As an example, assume Bob and Betty are high income professionals who do not have access to employer health insurance and buy private insurance on their own. They have a daughter, Mary, who is currently in college. Bob and Betty own an investment position worth $20,000 with a cost basis of $7,000 which they gift to their daughter, Mary. Mary then sells the position, recognizes the gain, and uses the proceeds to pay her college tuition expenses. She also applies for her own health insurance through the ACA exchange. All of this has several huge economic advantages:
- Mary now qualifies for ACA tax credits. Depending on where she lives, the credit could be upwards of $7,000/year – credits that would not have been available had she stayed on her parents’ plan.
- Because of her low income, Mary can sell the appreciated asset and pay 0% capital gains tax. This avoids the roughly $3,000 of tax that Bob and Betty would have faced on the sale.
- Since Mary is in college, she now qualifies for and benefits from tax credits not available to her parents. These could be worth a few more thousand dollars in tax savings.
We write all this with the recognition that the ACA credits may not exist beyond 2018. That said, there is still an opportunity at the close of 2017 to make use of the current law and to exploit several tax benefits in 2018. Additionally, any new tax law seems likely to continue providing the same economic incentive to a strategy like the one described above, even if the ACA credits do not exist beyond 2018.
Thoughts, questions, comments, or wonder if this strategy might be useful for your specific situation? Please do not hesitate to share these comments in the field below or email us.