Q. Can I continue to claim her as a dependent?
A. Yes, most likely. See explanation below.
Q. Or, would it be best to stop?
A. It's not really a choice. If she qualifies as your dependent, she is not allowed to "claim herself".
Q. How this will impact my taxes and/or hers depending on who claims this.
A. With the tax law change, effective 2018, most students will get the same refund whether they claim themselves or not. The personal exemption has been eliminated and the standard deduction increased. However, the student only qualifies for an education credit, if she is not a dependent*.
There are two types of dependents, "Qualifying Children"(QC) and Other ("Qualifying Relative" in IRS parlance even though they don't have to actually be related). There is no income limit for a QC but there is an age limit, student status, a relationship test and residence test.
A child of a taxpayer can still be a “Qualifying Child” (QC) dependent, regardless of his/her income, if:
- He is under age 19, or under 24 if a full time student for at least 5 months of the year, or is totally & permanently disabled
- He did not provide more than 1/2 his own support. Scholarships are excluded from the support calculation
- He lived with the parent (including temporary absences such as away at school, even living off campus) for more than half the year
So, it doesn't matter how much he earned. What matters is how much he spent on support. Money he put into savings does not count as support he spent on himself.
The support value of the home, provided by the parent, is the fair market rental value of the home plus utilities & other expenses divided by the number of occupants.
The IRS has a worksheet that can be used to help with the support calculation. See: http://apps.irs.gov/app/vita/content/globalmedia/teacher/worksheet_for_determining_support_4012.pdf
It somewhat depends on what the "financial aid" is, loans or scholarships. Scholarships are ignored in the support test (that is, scholarships, even taxable scholarships, are not considered as support provided by the student, herself). Loans, solely in the student's name is support provided by the student. Loans, co-signed by the parent, is considered parental support.
*Technically there is a provision that allows your student-dependent to claim a federal tuition credit. But, from a practical matter it seldom works out. A student, under age 24, is only eligible for the refundable portion of the American Opportunity Credit (AOTC) if he/she supports himself by working. She cannot be supporting herself on student loans & grants and 529 plans and parental support. It is usually best if the parent claims that credit.
If the student-dependent actually has a tax liability, there is a provision to allow him to claim a non-refundable tuition credit. But then the parent must forgo claiming the student as a dependent, and the $500 other dependent credit. The student must still indicate that he can be claimed as a dependent, on his return. This is worth up to $2500 (AOTC shifts to all non refundable).
Note: The AOTC can only be claimed 4 times. If this is her graduation year, chances are, it's the 5th calendar/tax year and her education is not eligible (whether claimed by the student or parents). She/you would be eligible for the lesser ($2000 max) Lifetime Learning Credit (LLC).
