Divorce settlement agreements specify who will be claiming the dependency exemption; and that exemption can be released in future years. Some tax breaks, for example the Child Care Credit, belong to the custodial parent even if that parent releases the exemption to the noncustodial parent. But what happens to the parent who pays child support and/or medical expenses and is not entitled to the dependent exemption?
Under an IRS Ruling issued in 2008, there are certain tax benefits that both parents are entitled to, regardless of which parent claims the dependent exemption. Both parents can treat the child as a dependent for the purposes of these tax breaks (for that child):
- Itemized deductions for medical expenses
- Tax-free employer reimbursements for medical expenses
- Tax-free treatment for employee discounts and no-additional-cost services
- Tax-free distributions from medical savings accounts (MSA) when the distribution is used to pay the child’s qualified medical expenses
- Tax-free employer provided coverage under a health plan
- Tax-free distributions from health savings accounts (HSA) when the distribution is used to pay the child’s qualified medical expenses
This rule only applies to parents who are divorced, legally separated, or live apart at all times during the last six months of the year and the following tests are met:
- Over half of the child’s support during the year is provided by the child’s parents
- The child is in the custody of one or both parents for more than half the year
- The child is a qualifying child or qualifying relative of one of the parents
In the case where one spouse is in a much higher marginal tax bracket that the other, maybe it would be more tax efficient to reduce child support and let the paying parent be responsible for more medical costs. This may also enable that parent to take advantage of some of the tax exclusions outlined above and produce tax savings that will help both parents’ cash flow.
This ruling further emphasizes the need for divorce financial planning while you are in the process. You may also want a divorce financial planner to review the settlement agreement once it is in draft form.