Tax Exemptions and Deductions for Families

As a family, you may be able to save more on your taxes than a single person can. Once you discover all the deductions available to you, you'll be able to save more money this year, and plan better for your family's future.

So if you're new to preparing your own income tax return, or if you just want to make sure you're taking advantage of every deduction that you're entitled to, this article is for you. We'll explain which deductions are available to your family, and also point out some deductions that many families overlook each year.

An exemption is an amount of money you can subtract from your Adjusted Gross Income, just for being you or having dependents. Exemptions reduce the amount of income on which you will be taxed.

In 2008 you can receive a $3,500 exemption for each qualifying child, which may include your child or stepchild, foster child, sibling or step-sibling, or descendants of any of these, such as your grandchild. To qualify for an exemption, the child must live with you more than half of the year and be under 19 at the end of 2008, or under 24 if a full-time student (defined as attending school for at least part of five calendar months of the year).

You no longer have to show that you provide more than half of the child's support, as required under pre-2005 rules, but the child cannot provide more than half of his or her own support for you to claim an exemption.

There is no longer a gross income test for a qualifying child, as long as he or she does not provide more than half of his or her own support. If you're married, you and your spouse are each entitled to a $3,500 personal exemption. (For 2009, exemptions will be worth $3,650 each.)

For a married couple with three young children, the total exemption deduction for 2008 is $17,500 ($3,500 x 5). If the marginal income tax rate for this family is 25 percent, that deduction saves $4,375 in taxes.

If your income exceeds a certain level, the law squeezes the value of your exemptions. For 2008, for example, the $3,500 value of each exemption is reduced if your Adjusted Gross Income (AGI) exceeds $239,950 for joint returns, $159,950 for singles and $199,950 for heads of household. 

This squeeze isn't as tight as it was in the past, when some families lost the full value of the exemption. Now you can't lose more than one-third of the value, no matter how high your income.  In other words, in 2008 each exemption cannot be reduced to less than $2,333. The personal exemption phase-out is scheduled to disappear after 2009.

Note: If you are subject to the Alternative Minimum Tax (AMT), a parallel tax system that is increasingly affecting middle-income taxpayers, you get no credit at all for your exemptions. The loss of this tax-saver is what pushes some large families into the AMT.

Many families also provide homes for relatives such as parents or grandparents, or support relatives who do not live with them. If you're in this situation, you can take an exemption for a qualifying relative, who is not a qualifying child, as long as the person you're claiming as a dependent meets all five of these criteria:

1. The person is either:
   
   1. A relative
   2. A full-time member of your household
2. He or she is a citizen or resident of the U.S. or a resident of Canada or Mexico.
3. He or she did not file a joint income tax return with anyone else.
4. You provided over half of his or her support.
5. The person in question has less than $3,500 of income for the entire year. If your child is not a qualifying child for 2008 because he or she does not meet the age/student test or the principal place of residence test, you may still be able to claim an exemption for the child as your qualifying relative, but only if he or she has gross income under $3,500, and you provide more than half of his or her support.

Although these tests seem straightforward, each has plenty of wrinkles, spelling out what to do in particular circumstances. For instance, who can be considered a "relative?"

A person who has lived with you for the entire year as a member of your household may qualify as a dependent, whether or not that person is actually a relative. But if the person did not live with you for the entire year as a member of your household, the nature of the relationship becomes important. Here's a list of people considered to be relatives:

• Children, grandchildren or stepchildren
• Siblings, including half or step-siblings
• Parents, grandparents or any other direct ancestors
• Stepparents
• Aunts or uncles
• Nieces or nephews
• Fathers-in-law, mothers-in-law, sons-in-law, daughters-in-law, brothers-in-law or sisters-in-law

There are special rules for children of divorced or separated parents and for persons receiving support from two or more individuals. If you are in this situation, read IRS Publication 504: Divorced or Separated Individuals.

The same person cannot be claimed as a dependent by more than one taxpayer, nor can a child who can be claimed as a dependent on his or her parents' return claim a personal exemption on his or her own return.

To claim anyone as a dependent, you must enter his or her Social Security number, or the equivalent, on your tax return. Using that number, the IRS software can tell fairly easily if two returns claim the same dependent, so make sure that you're entitled to the deduction before you prepare your return.

For more information, see IRS Publication 501: Exemptions, Standard Deductions and Filing Information.

You can deduct many medical expenses. You can deduct any expense you pay for the prevention, diagnosis or medical treatment of physical or mental illness, and any amounts you pay to treat or modify any part or function of the body for health—but not for cosmetic purposes. (So you can deduct the cost of LASIK eye surgery to correct your vision, but not the BOTOX® Cosmetic injections to smooth the wrinkles around your eyes.) You can also deduct the cost of transportation to the locations where you can receive this kind of medical care, your health insurance premiums, and your costs for prescription drugs and insulin.

Medical expenses are only deductible if you itemize, and only if they exceed 7.5 percent of your Adjusted Gross Income (10 percent if you are subject to the Alternative Minimum Tax). You can only deduct the medical and dental expenses above that floor.

Example: Emma's Adjusted Gross Income was $100,000, and she spent $8,000 on medical expenses. Because her expenses equal at least 7.5 percent of her AGI, she can take the deduction for the amount above $7,500. Her deduction is $500.

You can deduct medical costs you pay for another person according to the following rules:

• If you pay medical expenses for someone whom you do not claim as a dependent on your income tax return, you can deduct those expenses if:
  
  • He or she either lived with you for the entire year as a member of your household
  • He or she is related to you (as described in the section  Who's a Relative)
  • He or she was a U.S. citizen or legal resident, or was a resident of Canada or Mexico, for some part of the year
  • You provided over half of his or her support for the year

(Note that these rules are slightly less stringent than those for the dependency exemption. Therefore, it's possible that you can deduct medical expenses you paid for one of your parents, even if they filed their own joint return.)

• If you paid a person's medical bill this year for an expense incurred last year, and that person was your dependent last year, you can deduct the expenses on this year's return even if he or she isn't your dependent this year. The key factor is that the person was your dependent when the medical services were provided.
• If you're divorced and pay medical expenses for your child, but don't claim him or her as a dependent, you can still deduct those expenses. This assumes that you would otherwise qualify to take a dependency exemption for your child.
• You can deduct medical expenses that you pay for your spouse. What most people don't know is that you can claim medical expenses for your spouse's medical treatments that occurred before you were married if you paid those bills after your marriage. The rule is that you must be married either at the time of the medical treatments, or at the time the bills are paid.

For a complete list of qualified medical expenses, see IRS Publication 502: Medical and Dental Expenses.

In most cases, you can't deduct the cost of your child's educational expenses because they are considered personal expenses. However, the following deductions may help ease the tax burden somewhat:

• Deduction for college tuition expenses: This deduction is available to you regardless of whether or not you itemize your deductions (i.e., file Schedule A) on your income tax return. For 2008, the maximum deduction is $4,000. The maximum deduction drops to $2,000 and then disappears completely as income rises. Expenses that are eligible for the deduction are tuition and fees for college. These same expenses are also eligible for the Hope tax credit, but you won't be able to take both the deduction and the Hope credit for the same student in the same year.

The Lifetime Learning credit has fewer restrictions, because it applies to any courses above the secondary level. We recommend that you calculate your taxes both ways (one version with the deduction and one version with the credit) to see which one results in the lower tax. For IRS information on deducting higher education expenses, see IRS Publication 970: Tax Benefits for Education. 

• Education Savings Accounts: Formerly known as Education IRAs, Education Savings Accounts (ESAs) allow up to $2,000 each year to be contributed for each child under age 18. You actually pay taxes on the money you put into the account, but the earnings are not taxed when you withdraw the proceeds to pay for college. You can save a fairly sizable amount over several years before your family member needs the money for college.

The contributions aren't tax-deductible, but you can withdraw your investment earnings tax-free as long as you use the funds to pay for college costs. Moreover, if your child chooses not to attend college, you can transfer the balance to another member of the family.

You can use the money from an ESA to pay for elementary and high school education, as well as for college educational costs. While ESAs aren't considered a deduction for your family, they do represent a unique opportunity to realize additional tax benefits for the education of your family members.

• Student loan interest: Interest on loans you take out to pay for college or vocational school expenses is also deductible. The deduction limit is $2,500 in 2008, and the deduction is phased out for higher-income taxpayers. The phase out begins at $115,000 on joint returns and at $55,000 on individual returns.

• If you are the sole proprietor of your own business, consider employing your child (under the age of 18) for certain tasks. You can pay your child up to $5,450 in wages in 2008 (the amount of the standard deduction) without incurring income taxes and most employment taxes. The wages would be tax-free to your young employee and you could deduct the wages as a business expense on your own tax return.
• If you have a child going to college in another area, consider purchasing a house or a condominium for your child to live in. By treating the house or condo as a second home, you can deduct the mortgage interest and real estate taxes on your own tax return.

TurboTax Deluxe Edition asks you simple questions about your family to ensure you get every deduction, credit and exemption you deserve.

Updated for tax year 2008