Who gets to claim the children on their taxes in a divorce? This issue comes up a lot and it should, because the dependency deduction is more valuable than most people realize. We should be treating this tax advantage as an asset and using it to negotiate better outcomes for our clients. Let’s take a closer look at why.
The Advantage of the Dependency Deduction
Head of Household
Did you know that you have to claim a dependent in order to file as head of household on your tax return? Did you know that the standard deduction for head of household is significantly higher than the deduction for single filers? In order to qualify as head of household, you must pay at least half the cost of keeping up your home for the tax year and your home must be the primary home of a child that you can claim as a dependent for at least half the year. You must also be unmarried or “considered unmarried” to qualify. You are considered unmarried if your spouse did not live with you during the last six months of the tax year, you do not file as joint return, and you meet the other requirements to be considered a head of household.
How much is head of household filing status worth? It could be worth thousands. In 2020, the standard deduction is $12,400 for individuals and married couples filing separately; $18,650 for heads of household; and $24,800 for married couples filing jointly. If you file as head of household or jointly, you can avoid paying taxes on up to $6,250 of your income than you would if you file as single or married filing separate.
Filing as head of household doesn’t just save you from paying taxes on your income, it can also impact your tax bracket. That is where you can potentially see serious tax savings.
For the purpose of illustration let’s imagine a husband who earns $180,000 in income per year and a wife who earns $50,000 annually.
If the husband in this scenario files single, the standard deduction is $12,400 and he will have to pay income tax on $167,600. This puts him in the 32% tax bracket, and he will owe $53,632 in income tax.
If the husband files as head of household, the standard deduction is $18,650 and he will have to pay income tax on $161,350. This puts him in the 24% tax bracket, and he will owe $38,724 in income tax. For simplicity, graduated rates are not used for this example.
The husband would save $14,908 in income tax simply by filing head of household which he can only do if he has a dependent in the home.
The wife in this scenario does not benefit from the savings as much as the husband. If the wife files single, she will have to pay income tax on $37,600, and if she files head of household she will have to pay income tax on $31,350. Either way she is going to be in the 12% tax bracket.
If she files single she will owe $3,762 in income tax; and if she files head of household she will owe $4,512 in income tax-a difference of only $750.
Now imagine this couple has one child who is age three (3) and no other dependents. The husband has a potential tax savings of $14,908 a year until that child turns eighteen (18), if not longer. That’s $223,620. The wife would only save $11,250 over the same time period. Worth negotiating, don’t you think?
Child Tax Credit
In addition to the potential savings listed above, the party who claims the child as a dependent may qualify for a Child Tax Credit. If you are filing single or head of household and you earn less than $200,000 in adjusted gross income you get a child tax credit for qualifying dependents of $2,000. This is a dollar-for-dollar credit that reduces the amount of tax you owe.
That is a direct cash savings each year. In this scenario, the child is three years old. Assuming there are no changes to the credit over the next 14 years that is a savings of $28,000 for whichever party claims the child until he reaches the age of 17, when the credit expires.
If you add that to the standard deduction benefit and tax bracket savings in the scenario above, the husband has the potential savings benefit of $251,620, while the wife has the potential savings of only $39,250 if she claims the child as a dependent.
And there are even more benefits to claiming the child as a dependent.
Earned Income Tax Credit
There is another tax credit called the Earned Income Tax Credit. Single and Head-of-Household filers who earn less than $41,094 in adjusted gross income with one child and who earned less than $3,650 in investment income could receive an additional tax credit of:
- $3,584 for one qualifying child
- $5,920 for two qualifying children
- $6,660 for three qualifying children
In our scenario, the husband would not qualify because his earned income is too high, the benefit is only available to filers with income of up to $50,162, but the wife would qualify for an additional $3,584 in tax credits each year. If we extrapolate that out over the next fifteen years, the wife would have a potential tax savings of $93,010.
And there are still more benefits to claiming the child as a dependent.
Child and Dependent Care Credit
If you are paying someone to take care for your children while you work, you might be eligible for the child and dependent care credit. This credit “gives back” a portion of the money you spend on care and can reduce your tax bill by hundreds or even thousands of dollars.
This is a tax credit, which again reduces your taxes dollar-for-dollar. You can claim the credit regardless of your income. The childcare credit gets smaller at higher incomes, but it doesn’t disappear. In order to claim the credit, you must have paid someone to care for your child who is under the age of 13.
The parties can claim the credit for money they paid for care so long as the person they paid was not:
- A spouse
- A parent of the child being cared for
- Anyone listed as a dependent on your tax return
- His or her, own child age 18 or younger, regardless of whether he or she is a dependent on your tax return (i.e. a parent cannot pay her 17-year-old child to look after an 8-year-old sibling and then claim the credit)
There are some other qualifications:
- The parent must have earned income from a job; and
- Must have paid the childcare, in order to, work or look for work; and
- Provide the name, address and taxpayer identification number of the person who provided the care
The size of the credit is based on how much is spent for the childcare, as well as the parent’s income. The maximum amount of care expense one is allowed to claim is $3,000 for one child or $6,000 for two or more children. The amount of the credit is a percentage of the care expenses paid, and the percentage ranges from 20% to 35%. The higher your income, the smaller your credit, but there is no upper limit on income for claiming the credit.
A parent might save even more money if his or her employer provides a way to pay for childcare with “pre-tax” dollars. This may be possible with a Flexible Spending Account or similar account.
Even though a party is getting credit for their work-related child-care expenses in the child support calculator, those expenses could potentially be reduced by up to 35% or up to $3,000 for one child and $6,000 for two or more children a year through this credit. But in order to qualify for this credit you must be the custodial parent or main caretaker of the child or dependent.
The child in our scenario is three (3), and both of our parents are working parents. In theory this credit could be worth up to $3,000 for the next ten years or $30,000. That benefit, combined with the additional tax savings, could earn the husband in our scenario a total of $281,620 in tax savings, whereas the wife would only earn a total of $123,010 in tax savings.
Obviously, these tax issues which are much more complex in reality. There are many factors that could impact these tax savings. I am simply attempting to illustrate that the dependency exemption much more valuable than you or your clients probably thought. You should consult a qualified CPA or CDFA to assist you in this matter.
So who gets to claim the children on their taxes? The IRS guidelines clearly state that the parent who the child resides with more days out of the calendar year is eligible to claim the children as dependents. In an equal custody situation, since there are an uneven number of days in the year, this credit would alternate years.
We lost the ability to utilize tax deductions to negotiate alimony when the tax code changed in 2019. I have been in many mediations where the custodial parent (who is often the dependent spouse) either gives up the deduction or agrees to share the deduction and receives nothing in return. If parents understood the value of the deduction, perhaps they would recognize this as the opportunity to negotiate that value.
Kristen Shearin is an attorney, a Certified Mediator and a Certified Divorce Financial Analyst. She likes working with financially savvy clients but she also likes working with clients who don’t have that same level of understanding. She believes women should be empowered to be financially educated so they can control their financial future. www.psfamilylaw.com