JOINT OR SEPARATE? THAT IS THE QUESTION! - PART ONE

The “marriage penalty” is alive and well and thriving in our federal tax code!

Because of the way the tax rate schedules are constructed, dual-income married couples generally pay more federal and state income tax than they would if they were filing as two Single taxpayers. This is known as the “marriage penalty”. George W’s early tax cuts attempted to address the problem, and did provide a fix for lower income taxpayers who do not itemize. But it remains a real issue for most middle and upper middle- class taxpayers.

You may be able to slightly reduce the penalty by electing to file as Married Filing Separately.

Because of the 7½% of Adjusted Gross Income (AGI) exclusion for medical expenses and 2% of AGI exclusion for miscellaneous deductions, if one spouse has excessive deductions in either category applying the % exclusion to the separate AGI could produce a lower combined separate taxable income.

Let’s say a couple had $8,000 in deductible medical expenses for 2006, $6,000 of which was for dental work for the wife and $2,000 was for glasses and doctor bills for the husband. Their combined AGI is $100,000, of which $60,000 applies to the husband and $40,000 to the wife. If they filed a joint return they could claim a deduction for $500.00 of medical expenses ($8,000 less $7.500). If they filed separately, the husband could not deduct any medical expenses, as 7½% of his AGI ($4,500) is more than his $2,000 in medical bills. The wife, however, can deduct $3,000 ($6,000 less $3,000). By filing separately they get to deduct $2,500 more in medical expenses.

If the husband was an outside salesman and had $2,500 in net unreimbursed “employee business expenses” and the wife was a secretary with no job-related expenses, and they paid $100 in tax preparation fees for a joint 2005 return, they would be able to deduct $600 in miscellaneous expenses on a joint return ($2,600 less $2,000). On a separate return the wife would have no miscellaneous deduction, but the husband could deduct $1,350 ($2,550 less $1,200) - $750 more than on a joint return.

New Jersey married residents who both work can often save several hundred dollars in state income tax by filing separate state returns. This is because the state tax table for Married Filing Separately is the same as for Single taxpayers. In addition, as NJ allows a deduction for medical expenses, filing separately could produce a higher combined separate deduction for medical costs. However, you generally must use the same filing status on your NJ-1040 as you do on your federal 1040. In such a case it could pay to file separate federal returns even if doing so resulted in a slightly higher combined federal tax liability. You may pay $200 more in federal income tax, but save $300 in NJ state income tax.

As I stated in my January 20 posting on CHECK OUT ALL YOUR OPTIONS, if you find yourself faced with choices you should do separate tax calculations to see which one will result in the lowest tax. In this situation you will need to calculate three (3) sets of federal and state tax liabilities, one for a joint return and one each for the husband and wife’s separate returns. If you live in NJ and work in NY be sure to include New York state tax calculations. Because the dreaded Alternative Minimum Tax (AMT) increases the AGI exclusion for medical expenses to 10% and does not allow a deduction for miscellaneous deductions you should calculate the AMT as well as the “regular” tax when doing your tax liability comparisons.

In certain situations you will not be able to receive a specific tax benefit, or you will receive a reduced benefit, if you file separate 1040s -

· You cannot claim the Credit for Adoption Expenses, the Credit for Child and Dependent Care Expenses, the Earned Income Credit, the Credit for the Elderly or Disabled, or the HOPE or Lifetime Learning Education Credit.

· You cannot claim an Adjustment to Income for tuition and fees, student loan interest, or a spousal IRA.

· You will probably be ineligible for a ROTH IRA or a deductible IRA if an active participant in an employer pension plan.

· You will not be able to exclude from income savings bond interest used for qualified educational expenses.

· A greater amount of your Social Security benefits may be taxed.

· The maximum net loss deduction is limited to $1,500 for each spouse.

· You will not be able to deduct a loss on rental property.

· One spouse’s passive loss cannot be used to reduce or wipe out the other spouse’s passive income.

· You will not be able to convert a traditional IRA to a ROTH IRA.

In such situations if you wanted to file separately to save on NJ state taxes the additional federal tax cost of filing separate returns could far outweigh any state tax savings.

If the husband and wife lived apart for the entire year, or in certain cases for the last 6 months of the year, they will be able to file separately and still receive the full tax benefit for some of the items listed above.

If one spouse claims itemized deductions on a separate return, the other spouse must also itemize. One spouse cannot itemize and the other claim the standard deduction.

If increased medical or miscellaneous deductions are not an issue, you will generally receive the greatest combined federal and NJ state tax savings from filing separate returns if the individual taxable incomes of the spouses are relatively equal. As the spread between the two separate incomes increases the net tax savings will decrease until eventually filing separately will produce a higher net combined tax liability.

Most tax preparers will automatically prepare a joint return without comparing the options. If you use a paid preparer and you think you may be able to pay less net tax by filing separately, ask him/her to calculate the federal and state tax both ways. It will cost a bit more, but it may end up putting more money in your pocket.

Unfortunately, you cannot file an amended return to change your filing status from joint to separate after the initial due date for that return has passed. If you file a joint 2006 Form 1040 in February you can change to separate in March, but you cannot change to separate after April 16, 2007.

Tomorrow – how to allocate income and deductions between the spouses.

TTFN