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Last week we discussed the "marriage penalty" and how it may impact you as a taxpayer. The obvious next question then is: "Should my spouse and I file using the married-separate filing status in order to avoid the marriage penalty?" As is often the case with tax questions, there is no clear-cut answer. It depends on your individual tax situation.
In general, your decision will depend on which filing status results in the lowest tax. But there is one very important consideration that you should take into account. If you and your spouse file a joint return, each of you is jointly and severally liable for the full amount of tax and any interest or penalty due on a joint return. This means that if your spouse decides to take the cash out of the bank and run away to Costa Rica, YOU could be stuck with the total tax liability. Therefore, regardless of which method results in less tax, you may choose to file a separate return if you want to be responsible only for your own tax.
In most cases, filing jointly offers the most tax savings, particularly where the spouses have different income levels. The "averaging" effect of combining the two incomes can bring some of it out of a higher tax bracket. For example, if one spouse has $75,000 of taxable income and the other has just $15,000, filing jointly can save about $1,500 in taxes over filing separately.
But remember that filing separately doesn't mean you go back to using the "single" rates that applied before you were married. Instead, each spouse must use the "married, filing separately" rates. These rates are based on brackets that are exactly half of the married filing joint brackets, but are still less favorable than the "single" rates. This means that the "marriage penalty" can't necessarily be eliminated simply by filing separate returns.
But there is a potential for tax savings from filing separately where one spouse has significant amounts of medical expenses, casualty losses, or "miscellaneous itemized deductions." These deductions are reduced by a percentage of adjusted gross income (AGI). Medical expenses are deductible only to the extent they exceed 7.5% of AGI, and casualty losses must exceed 10% of AGI. Miscellaneous itemized deductions, which include a variety of deductions such as investment expenses (other than investment interest), non-reimbursed employee expenses, and tax return preparation costs, are deductible to the extent their combined total exceeds 2% of AGI (often referred to as a "2% floor").
If these deductions are isolated on the separate return of a spouse, that spouse's lower (separate) AGI, as compared to the higher joint AGI, can result in larger total deductions. For example, if one spouse has $7,000 in medical expenses and the couple's joint income is $90,000, then only $250 is deductible on a joint return, because 7.5% of $90,000 is $6,750 (and $7,000 - $6,750 = $250). But if the income of the spouse with the medical expenses is only $15,000, the deduction increases to $5,875 on a separate return, because 7.5% of $15,000 is only $1,125 (and $7,000 - $1,125 = $5,875).
On the other hand, the amounts you claim as a deduction for exemptions and for itemized deductions, including miscellaneous itemized deductions, are phased out (i.e., reduced) once your AGI goes above a certain limit, depending on your filing status. The limit is higher for joint returns than for separate returns.
For example, in the case of the phase out of personal exemptions, the AGI threshold in 1998 for joint returns is $186,800 as compared to only $93,400 for separate returns. Thus, if you file a separate return, your deduction for exemptions is phased out if your AGI exceeds $93,400. But if you and your spouse file a joint return, your deduction for exemptions doesn't begin to phase out until your AGI exceeds $186,800. This means that a phase out that might be suffered on a separate return may be avoided if you and your spouse file a joint return. The amount of tax savings at stake will vary depending on how many exemptions are claimed and your income levels. There are also similar phase out rules that apply for the reduction of your itemized deductions that may be affected by the married/separate decision.
There are many other tax factors that will weigh into your decision of filing jointly or separately. For example, the child and dependent care credit, adoption expense credit, and Hope and Lifetime learning credits are only available to a married couple filing a joint return. And you can't take the credit for the elderly or the disabled if you file separate returns unless you and your spouse lived apart for the entire year. Nor can you deduct qualified education loan interest unless a joint return is filed. You may also not be able to deduct contributions to your IRA if either you or your spouse was covered by an employer retirement plan and you file separate returns. And a Roth IRA contribution or conversion is virtually out of the question. Nor can you exclude adoption assistance payments or any interest income from series EE savings bonds that you used for higher education expenses if you file separate returns.
In addition, Social Security benefits are in some instances more heavily taxed to a couple filing separately. The benefits are tax-free where modified AGI does not exceed $32,000 for a joint return, but the base amount is zero on a separate return.
The decision you make for federal income tax purposes may have an impact on your state income tax bill, so the total tax impact has to be compared. For example, an overall federal tax saving by filing separately might be offset by an overall state tax increase, or a state tax saving might offset a federal tax increase. Obviously, this will depend on your state of residency and the laws of your state. But it is certainly an issue that must be considered before making your final decision.
Unfortunately, I can't give you any hard and fast rules of thumb for when it pays to file separately. The tax laws have grown so complex over the years that there are often a number of different factors at play for any given situation. The only real way that you can determine exactly which filing status is best for you is to "run the numbers," prepare your tax returns using both methods, and make your decision. It can be a difficult process. For those of you who use computer tax programs, the preparation of these returns is less daunting IF you know the law and apply it correctly.
Finally, those of you residing in "community property" states have even more issues to deal with when trying to separate joint income and assets. And we'll discuss those issues in greater detail next week.
Please note that Roy cannot answer individual questions via e-mail. If you have tax questions, please ask them on the taxes message board. Thanks!