Exemptions - different from deductions
Next come your exemptions. Each exemption you claim can lower your taxable income by about $2,500, and this amount increases each year with inflation.
Note that exemptions have nothing to do with your deductions, including the standard deduction. It's true that both exemptions and deductions reduce your taxable income, but they're different things.
Put simply, exemptions deal with the number of people living in your household, while deductions deal with your lifestyle.
For example, if you're over age 65, you still get only one exemption. But if you're over 65, you get a higher standard deduction. Same thing if you're blind. One exemption, but a higher standard deduction.
Or suppose you live in a big house with a big mortgage. This lifestyle leads to a big mortgage interest deduction, but it doesn't affect the number of exemptions you can claim. Exemptions and deductions are different.
Figuring out your number of exemptions
So determining the number of exemptions you can claim should be as easy as counting the number of warm bodies in your home. Unfortunately, it's not that easy.
If you're not a dependent, you can claim yourself as an exemption. If you're married, filing jointly, you can claim your spouse.
Your marital status is determined as of the last day of your filing year, usually December 31. If you were married to someone on December 31st, according to the IRS you were married to that person for the whole year.
When it comes to dependents, however, things get murkier.
The value of an exemption
Because each dependent you claim cuts your taxable income by about $2,500, a middle-class taxpayer in the 28 percent bracket cuts his total tax liability by about $700 for each dependent he claims.
So there's an incentive to claim as many dependents as possible. I've even heard stories of people claiming their dogs as dependents.
To help prevent this, the IRS requires you to give the Social Security number of each dependent you're claiming. You should be careful that you and an ex-spouse both don't claim the same child, because the matching Social Security numbers will trigger a letter from the IRS.
So now for the $700 question : How do you determine if a person is your dependent or not?
IRS' five rules for finding dependents
The IRS has five tests that must be met. The first is citizenship. Only residents of the US, Canada or Mexico can be a dependent.
The second test is gross income. If the person made more than the exemption amount, that is $2,550 in 1996, they can't be a dependent. But, and this is a big but, this requirement is waived for children under age 19 and students under age 24.
The gross income requirement usually affects elderly dependents. If you're helping to support your mother, and she receives $5,000 in interest income, you can't claim her as a dependent.
The third test is the relationship test. You normally can only claim a blood relative, but there's an exception. If a non-relative was in your home for the entire year, you might be able to claim her.
The fourth test is the support test. You must provide over half of the total support of a person to claim that person as a dependent. There is a provision, however, for one person to claim the exemption even if several people provided support.
Claiming the exemption for the children of divorced parents is tricky. After 1984, Congress said that the parent who has custody of the child for the majority of the year can claim the exemption. However, this right can be waived with Form 8332. Giving the right to the person with the higher income can lead to some tax arbitrage savings.
The fifth test states that a dependent may not file a joint tax return with someone else.
To summarize, you almost always should be able to claim your children who are under 19 as your dependents. With anything else, say an elderly parent or a foster child, you'll have to check the IRS instructions. But if you are helping to support someone, you should look into claiming them as a dependent because this could save you $700 in taxes.