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Tax Planning with Marriage in Mind

For Richer or Poorer

Marrying creates a tax situation that can either increase or decrease taxes significantly.

Marital status on the last day of the year applies for tax purposes for the entire year. This means that late-in-the-year marriage can have a retroactive effect - changing tax bracket rates and available deductions for the entire year.

It also creates a timing opportunity - if marriage will reduce taxes, then getting married by December 31 can cut the full year's tax bill. But, if marriage will increase taxes, delaying marriage until next year will avert a tax increase this year. Key tax effects of marriage:

• The marriage penalty. The so-called "marriage penalty" increases the tax owed by two individuals who have approximately the same amount of taxable income when they marry each other.

This is due to tax bracket rates being higher on a joint return at income levels lower than twice the levels on a single return. So when individuals with similar incomes add them together on a joint return, they are likely to be subject to a higher top bracket rate than on a single return.

The marriage penalty has been reduced, but not eliminated, by the Jobs and Growth Tax Relief Reconciliation Act of 2003. It expanded the 15% tax bracket and the standard deduction on a joint return to cover twice the amounts they do on a single return.

This eliminates the penalty for moderate-income taxpayers (up to $59,400 on a joint return in 2005) who don't itemize deductions. But the penalty continues to exist at higher tax brackets, which still apply on joint returns at less than twice the level on single returns. Examples:

The 28% tax bracket begins at $71,950 on a single return but at $119,950 on a joint return.

The 33% tax bracket begins at $150,150 on a single return but at $182,800 on a joint return.

The 35% tax bracket begins at $326,450 on both single and joint returns.

The marriage penalty can also have an effect through itemized deductions. Some deductions are allowed only to the extent that they exceed a percentage of adjusted gross income (AGI).

Examples: Casualty losses to the extent that they exceed 10% of AGI, medical deductions to the extent that they exceed 7.5% of AGI, and miscellaneous deductions to the extent that they exceed 2% of AGI.

If one spouse has such a deduction, combining two persons - AGI on a joint return will reduce the deductible amount.

Example: One spouse has a large casualty loss and medical expenses that could have been deducted on a single return reporting AGI of $60,000. If they are instead deducted on a joint return showing AGI of $120,000, the deductible amount of the casualty loss will be reduced by an additional $6,000, and that of the medical expenses by an additional $4,500.

In addition, passive losses from real estate that is actively managed by the taxpayer are deductible up to $25,000 only if modified AGI does not exceed $100,000.

And, itemized deductions generally are reduced by 3% of the extent to which AGI exceeds $145,950 on either a joint or single return in 2005.

So increasing AGI can reduce these deductions as well.

• IRAs and retirement accounts. If only one spouse has earned income, marriage increases allowable deductible IRA contributions by permitting the spouse with earned income to make a contribution of up to $4,000 in 2005 for the nonworking spouse.

However, converting a regular IRA to a Roth IRA is allowed only when AGI does not exceed $100,000 on a single or joint return - so combining two incomes to total more than that amount will make a conversion impossible.

Beneficiary traps: Deduction limits for employer-sponsored plans such as 401(k)s aren't affected by marriage - but beneficiary designations may be. Federal law generally requires a spouse to be a plan participant's beneficiary unless the spouse waives his/her rights - so marriage may have the unexpected effect of changing beneficiaries. Examine your plan beneficiary designations with an expert.

• Social Security benefits. These are subject to marriage penalty - type taxation. Up to 50% of benefits are taxable if "provisional income" (basically AGI, tax-exempt income, and half of Social Security benefits) exceeds $25,000 on a single return or $32,000 on a joint return - less than twice the single-return amount. Up to 85% of benefits are taxed if income exceeds $34,000 on a single return or $44,000 joint.

So combining incomes on a joint return may increase the tax on Social Security benefits.

• Personal residences. Marriage may save tax on the sale of a highly appreciated home. A single person can take up to $250,000 of gain tax free on a home if he owned it and lived in it as a principal residence during at least two of the prior five years.

But for a married couple, the maximum tax-free gain is $500,000 - and only one spouse need be owner of the home, though both must meet the two-year residency requirement. If you married someone who has used the exclusion within the previous two years, that person's exclusion would not be allowed and the couple would be limited to $250,000. Tactics:

If one spouse owns a home that has appreciated in value by more than $250,000, sell it after marrying and after both spouses have lived in it for two years. You can even do this sequentially with two homes, selling the second at least two years after the first.

When an unmarried couple has lived together for two years in a home owned by one of them, they can marry and then sell the home immediately for up to $500,000 of tax-free gain. In fact, they can even sell the home before they marry, so long as they marry by December 31. They meet the requirements because they filed a joint return for the year, one of them owned the house, and they both used it as their residence for the two years - even if they weren't married while they did.

• Estate tax. When one spouse owns significant assets and the other doesn't, marriage can increase the amount of their total wealth that will escape estate tax, by permitting use of two personal "exempt amounts."

An individual can leave $1.5 million in assets free of estate tax in 2005. So if one single person has $2.9 million of assets and another has $100,000, the wealthier person faces estate tax on $1.4 million. But if the two marry, they can equalize their estates (such as by using tax-free marital gifts) at $1.5 million to eliminate all estate tax.

After marrying, they can also use tax-free joint gifts (up to $22,000 per recipient annually) to make larger estate-reducing transfers to the younger generation than one could while single ($11,000 per gift).

Adjusting

The retroactive effect of a marriage that occurs well into the year can produce either a surprise big tax bill or a tax overpayment that you may have to wait months to have refunded.

Best: Calculate the tax effects of marriage beforehand. Then, if you are sure you will marry, modify your estimated and withheld tax payments before you marry, to make the smoothest possible adjustment for year-end liabilities.