Here are four different types of child-related tax credits that divorcing parents should understand before resolving custody issues.
By Noah Rosenfarb
In general, there are four different types of tax credits that divorcing parents should understand before resolving which parent will claim the dependency exemption and/or how joint custody should be addressed in an agreement.
Earned Income Credits (Claimed by Custodial Parent)
The earned income tax credit (or EIC) is a refundable credit (meaning if the credit exceeds the tax liability, the IRS will mail the taxpayer money) that is often the most valuable of all the tax credits. It can only be claimed by the custodial parent. The value can be slightly more than $3,000 if the taxpayer has one child to more than $5,500 for three or more children. To claim the credit, a taxpayer must have earned income of less than $35,535 with one qualifying child and up to $43,352 for three or more qualifying children.
There are other qualifying rules that impact the calculation. For example, if you have more than $3,100 in investment income, then you cannot claim this tax credit.
Child and Dependent Care Credit (Claimed by Custodial Parent)
If a custodial parent pays for care for a qualifying dependent that was age 12 or younger when the care was provided or for other dependents that are not able to care for themselves, then they may be eligible for the child and dependent care credit. To qualify, one must satisfy all of the IRS tests summarized below:
- You must keep up a home that the dependent lives in — paying at least half of the cost associated with owning and running the home.
- You must have earned income for the year, and the payments for care were required to earn income.
- You must identify the care provider on your taxes and they cannot be someone you could claim as a dependent (i.e. not an older child).
This credit can be up to 35% of up to $3,000 of expenses associated with the care of one individual or up to 35% of $6,000 for two or more individuals. If the taxpayer’s adjusted gross income is more than $15,000, they will receive less than the full credit (i.e the “phase out” begins). However, for taxpayers with more than $45,000 of adjusted gross income, the credit is still 20% of qualifying expenses (i.e. up to $600 for one child, $1,200 for two or more). Note this credit is not refundable.
Child-Related Tax Credits (For Parent Claiming Dependent)
Taxpayers may be able to claim a child tax credit of $1,000 for each qualifying child. In this case, a qualifying child is one that is claimed as a dependent, was age 16 or younger at the end of the year, and is a child that is the taxpayer’s own (or that of their brother or sister and is cared by them as their own child). The child tax credit is phased out if adjusted gross income is above $75,000 for Head of Household and Single filers. Note this credit may be refundable.
Education Tax Credits (For Parent Claiming Dependent)
There are two tax credits that presently apply to education — the American Opportunity Tax Credit (“AOTC”) and the Lifetime Learning Credit (“LLC”). In any year, a parent claiming a dependent can only take one of the credits.
The maximum AOTC is $2,500 and is subject to phase out when modified adjusted gross income is over $80,000 (or $160,000 for jointly filed returns). 40% of the credit is refundable. Note this credit is due to expire after 12/31/12.
The LLC is 20% of the first $10,000 paid for qualifying tuition and related expenses each year. The maximum credit is currently $2,000. Expenses for graduate and undergraduate work are eligible. There is no limit on the number of years that this credit can be claimed. The amount of the credit is phased out if modified adjusted gross income is between $50,000 and $60,000 ($100,000 and $120,000 if you file a joint return).
Often it is the case that after divorce, one taxpayer can benefit from the above tax credits to a greater extent than the other. So, when negotiating a divorce settlement, learn how the various tax credits would benefit each party. Splitting dependency exemptions is a common practice, but may not take into account how the various tax credits benefit each taxpayer.
(Reprint with permission.)
Noah B. Rosenfarb, CPA is Managing Director at Freedom Divorce Advisors where he provides sophisticated tax and financial advice to affluent divorced women. Mr. Rosenfarb integrates life planning with financial planning to ensure clients experience the maximum benefits of affluence post-divorce. His holistic approach increases the probability of leading a life that is filled with prosperity – the kind that is measured more by personal happiness than merely by currency.