Claiming Adult Children on Your Taxes

Watching our children grow up and leave the nest brings mixed emotions. Alas the prolonged economic downturn has forced thousands of young adults to move in with their parents until their job prospects improve.

On the cusp of tax season, a lot of parents are grappling with an issue: Can you claim an adult child as a dependent? For 2011, each dependent reduces your taxable income by $3,700. For a family in the 25% tax bracket, that works out to a tax savings of $925, which buys a lot of groceries.

Unfortunately, the fact the you provide a roof and food for an adult child does not automatically mean you can claim that individual as a dependent. There's a four point litmus test to determine if your child meets the IRS definition of "qualifying child".

1. Relationship. The individual must be your child, stepchild, foster child, sibling, stepsibling or a descendant of one of those (such as a grandchild).

2. Age. They must have been under age 19 at year's end, or under 24 if the child was a full-time student for at least five months of the year.

3. Residence. The child must have lived with you for more than half of the year. There are some exceptions for children of parents who are separated or divorced.

4. Support. You must have paid more than half of the child's support during the year. To calculate how much you spend on support, you can include your child's college costs, food, clothing and medical and dental expenses.  If your child is on your health insurance plan,  you can include a portion of your premium.  You can also include a percentage of your ongoing household expenses when calculating the amount you spend on support.  For example, if  five people live in your home and one is an adult child, you can include one-fifth of your utility bills.  As long as your child's income doesn't exceed the amount you spent on support, and meets the other criteria, you can claim the child as a dependent.

For example, if your son graduated from college in May, found a job in September and earned $20,000. As long as the amount you spent on his education exceeded $20,000, you can claim his as a dependent. However, if you claim your child as a dependent, he can NOT claim personal exemption on his own tax return.

Qualifying Relative
The increasing trend of adult children living with parents is not limited to recent college graduates.  Thousands of adult children who have been out of college for a year or more have been forced to move in with their parents because they can't find a job, or lost their job or homes or both.

If you're supporting an adult child who fails the age test, you may still be able to claim him or her as a "qualifying relative".  Be advised, though, that the standard for qualifying relative is much higher.

In addition to the "Support" and "Residence" criteria,  the qualifying relative must have earned less than the amount of the personal exemption.  This income test prevents a lot of parents from claiming older adult children as dependents because even a part-time job will render the child ineligible.

At the other end of the generational spectrum, hard times have also forced many families to take in older parents, or provide them with financial support. Claiming a parent as a dependent may be easier than claiming an older child for two reasons:

1. Social Security isn't included in the gross income test.  If Social Security is your parent's sole source of income, the income test isn't a problem for you. However, you can't claim a parent who earns $3,700 or more from other sources, such as a pension, interest of dividends.parent

2. Your parent doesn't have to live with you. Suppose your parent lives in an apartment or assisted-living facility, but you pay most of the bills. You can claim that parent as a dependent, as long as the other tests are met.


If you are in a similar situation but are unsure and need to ask questions, contact me for a consultation.
Keep Life Simple.
Liz

4 Financial Tips You Should Ignore

Have you heard the one about houses being a sure-fire investment? Or the tip that you should close all your credit card accounts? Bad financial advice can circle the web faster than the latest e-mail scam from Nigeria, and some of it originates from personal finance gurus themselves (although their words are often twisted). Here are four popular financial tips you should ignore:

1. A house is always a good investment. The man who calls himself "Frank Curmudgeon" built a popular website around what he considers to be terrible financial advice. Ask him what the worst is, and he'll tell you it's the idea that "you should borrow up to your eyeballs to buy the biggest house you can, because houses are the magic asset that never lose value." Pre-housing crisis, he says, "just about every mass market personal financial guru out there" advocated some form of that advice. Many people who took it to heart later found themselves unable to afford the houses they had bought, he adds.

My personal advice--never by a house or car or other purchase if it means living on the edge. Always leave yourself a cushion for emergencies, vacations, unexpected purchases.  Many self-made millionaires were frugal and saved and lived below their means for years before investment. A little sacrifice over years can amass to wealth later.

2. Avoid credit cards. Contrary to popular myth, credit cards do not spread the plague. In fact, people who take the "credit cards are evil" message to heart can find themselves in trouble when they want to borrow money for a house or car, since lenders want to see some experience with credit.

My 25-year-old daughter ran into the same problem when she tried to take out a loan for the purchase of her first, new vehicle and lenders turned her down. The reason, they told her, was that her credit record was simply too light. Since she had paid off her student loans and didn't use much credit elsewhere, they had no way of knowing whether or not she would be responsible with a loan. The bottom line: You have to use credit to be able to take out loans. They key is be responsible in paying off the debts. Take time to sit down with your high school children and teach them the values of money. 

3. All student loan debt is good debt. Zac Bissonnette, author of Debt-Free U, calls this the worst advice ever: "Borrow whatever it takes to go the best school you can. It's an investment in your future." Instead, he urges college students (and their parents) to avoid loans, reject the hype of expensive, private schools, and instead pay for more affordable colleges through a combination of hard work and being savvy.

4. Use home equity loans to pay off credit card debt. In pure mathematical terms, this proposition can make sense, since interest rates on credit cards are usually much higher than home equity rates. But here's why it's a bad idea, as many people, including MSN's Liz Pulliam Weston and Jeremy Vohwinkle of GenXFinance.com, have pointed out: Home equity loans can not only enable a debt-fueled lifestyle, but they can also leave you more vulnerable to foreclosure, bankruptcy, and other over-spending problems.

Have any tips you'd like to share from personal experience? Click on comments below.