Every year, several of my friends and acquaintances get married. At least one of them meets me at a dive bar to ask whether they should file their tax returns separately. Usually it is due to one of the following situations:
- A spouse is surprised to learn their new partner is reporting only $30,000 of income last year but is about to pay $4,000 per month mortgage payments without any help.
- At least one spouse is disorganized and tends to procrastinate. A conversation about taxes resembles a scene from the Simpsons.
- One spouse insists on filing separately because they are on IBR. The other spouse has no idea what IBR is.
- The spouse says nothing at all. They sign the tax returns without asking questions.
So when are spouses better off filing separately?
It comes down to balancing two factors: saving money and avoiding a dispute with federal and state tax agencies. Filing separately can also reduce federal student loan payments. These factors should be considered together when deciding to file separately.
Paying Less in Taxes
In most cases, filing jointly is beneficial because you will pay less in taxes. For middle-class income couples, the tax savings can be significant. In addition to more favorable income tax brackets, you can take advantage of various tax deductions and credits including:
- Student loan interest deduction
- Child tax credit
- Education deductions and credits
- Traditional IRA contributions
- Any available state tax deductions and credits
However, if you file separately, you will lose the above deductions and credits.
In some cases, you may pay less tax by filing separately. This is usually the case when one spouse has a low adjusted gross income but high itemized deductions, especially employee expenses and medical payment deductions. Unfortunately, because of the complexity of how the tax laws interact, it is near impossible to give simple examples. It is best to consult with a tax professional to see how the tax bill will differ if you file separately as opposed to jointly.
It is a different story if you and your spouse are a high-income couple. Your income will disqualify you from many of the above deductions and credits. Your itemized deductions can be limited. Finally, you may also have to pay the Alternative Minimum Tax in addition to a regular income tax. Because of this, your marginal tax savings will be lower.
Another problem with being high-income couple is your returns have a higher chance of being audited by a tax agency. You should consider whether the tax savings is worth the time and administrative costs of dealing with an audit, which brings us to the next issue.
Preventing a Tax Controversy Headache
When you file a joint return, each are jointly and severally liable for the entire tax debt, penalties, and interest. In other words, both you and your spouse can be liable for the mistakes or fraudulent activities of the other. If the tax debt is large enough and nothing is done to resolve it, then you may both be subject to tax liens, bank levies, wage garnishments and even criminal action.
Under these circumstances, I would recommend filing separately:
- If your spouse is unable to or refuses to sign off on a joint tax return. You can always amend your return to married filing jointly when they change their mind.
- If you think your spouse is cheating on their taxes.
- If you are cheating on your taxes.
- If neither of you are cheating on your taxes, but you think your numbers might put you at a high audit risk and you want to protect your spouse. Generally, self-employed Schedule-C filers with six-figure gross incomes have the highest risk of audit at a heart-attack inducing 3%.
- If you are separated or divorce is imminent. When a marriage is on the rocks, there are going to be fights over tax refunds or the soon-to-be ex might try to steal yours. And there’s the awkward possibility of the two of you walking down the aisle together one more time … to the IRS auditor’s office. If the tax savings is negligible, then it may be better to just pay the extra tax in exchange for avoiding a potential confrontation.
Reduce Your Monthly Student-Loan Bill
In recent years, more married couples are filing separately to reduce their federal student loan payments under the Income Based Repayment (IBR) or Pay As You Earn (PAYE) programs. Under these programs, if a debtor files married filing jointly, then the couple’s combined income will be used to determine the monthly student loan payment. But if the debtor files separately, only their income will be considered. While you will likely pay higher taxes, this can be offset by the savings in monthly student loan payments.
The savings can be significant. To use a very simple example, suppose a married couple has a combined adjusted gross income (AGI) of $170,000 if their return was filed jointly. If filed separately, the wife’s AGI is $130,000 while the husband’s AGI is $40,000. Let’s also assume that the couple pays around $1,500 in additional taxes by filing separately. Finally, let’s suppose the husband has $120,000 in federal student loan debt.
Using this IBR payment estimator, if the couple files jointly, their $170,000 AGI would disqualify the husband for reduced payments under IBR or PAYE. The minimum monthly payment the husband would qualify for is $700 under the 25 year extended graduated repayment plan. On the other hand, if the couple filed separately, the husband would only have to pay $201 per month under IBR or $134 per month under PAYE. At best the husband will save $566 per month ($700 – $134 = $566) or $6,792 per year in student loan payments.
So by filing separately, the couple will pay $1,500 in additional taxes but with the student loan payment savings, the couple will save $5,292 overall ($6,792 – $1,500 = $5,292).
But there are drawbacks. By paying less through IBR or PAYE, your overall student loan balance will be higher and you will pay more in the future unless you are planning for loan forgiveness. Also, under the proposed Revised Pay As You Earn (REPAYE) program, married borrowers would have their monthly payment amount calculated based on the couple’s combined income, regardless whether they file their returns jointly or separately.
Unfortunately, few CPAs and other professional tax preparers are aware of IBR and PAYE because most of them did not finish school with six figure student loan debt. I recommend working closely with your tax preparer to ensure that you pay the optimal taxes while minimizing your student loan payments.
In most cases, it is best to file jointly. But you should consider filing separately in one or more of these situations:
- If both spouses have high incomes and lots of deductions.
- If at least one spouse is on IBR or PAYE.
- If you think you or your spouse may be at risk for a tax audit.
In some cases, you may pay less in taxes by filing separately. But if one or both spouses are enrolled in the IBR alternative repayment programs, filing separately may result in greater overall savings. Even if you pay more by filing separately, the payment may be worth the peace of mind of not being liable for your spouse’s tax mistakes.
Featured image: “couple doing bills” from Shutterstock.