How to Maximize Personal Exemptions

Remember those generous personal and dependency exemptions you have claimed in the past? Under new rules taking effect on 2013 federal income tax returns, exemptions are reduced for certain high-income taxpayers. However, depending on your circumstances, you may still be in line for a significant tax break.

Basic rules:For starters, every taxpayer is entitled to claim a personal exemption for himself or herself, plus an exemption for a spouse if you file a joint tax return. The exemption amount, which is indexed annually, is $3,900 for 2013 (increasing to $3,950 for 2014). In addition, you may claim exemptions for each one of your qualified dependents.

To qualify for a dependency exemption, you must meet all four of the following requirements:

  • You are not a dependent of another taxpayer. Individuals who are dependents are not eligible to claim dependents.
  • The individual being claimed as a dependent cannot be married and filing a joint return. Exception: A married person can file a joint return and still be claimed as a dependent if the joint return claims only a refund of tax withholding or estimated tax payments and there would be no tax liability for either spouse if they had filed separate returns.
  • The individual being claimed as a dependent is a citizen, national or resident alien of the United States, or a resident of Canada or Mexico.
  • The individual being claimed as a dependent meets the definition of being either a qualifying child or a qualifying relative.

Generally, this means that you must provide more than half the annual support being provided to the individual being claimed as a dependent and that person must have less than the personal exemption amount in gross income subject to tax. For a child who is younger than 19 or a full-time student younger than 24, the “gross income” part of the test does not apply.

New rules:Under the personal exemption phaseout (PEP), the total amount of personal exemptions you may claim, including any dependency exemptions, is reduced by 2% for each $2,500 or portion of your adjusted gross income (AGI) exceeding a specified dollar threshold. For 2013 returns, the threshold is $250,000 for single filers and $300,000 for joint filers.

For example, suppose that a married couple has an annual AGI of $400,000 and is entitled to a total of four personal exemptions. Under the PEP, their personal exemptions are reduced by 2% of each $2,500 above the limit, or a total of 80% ($100,000 divided by $2,500 times 2%). Result: Their personal exemptions of $15,600 ($3,900 times 4) are reduced to $3,120 [$15,600 minus (80% of $15,600)].

The PEP rule was reinstated by the American Taxpayer Relief Act of 2012, along with another rule reducing many itemized deductions for high-income taxpayers.  These two new rules may have a significant impact on your 2013 return.