As we approach the final months of the 2010 wedding season, I have found that newlyweds and the newly engaged have been asking me one question with surprising frequency: “What is the ‘marriage penalty’ and how can we avoid it?”
Like most tax and legal matters, properly discussing the marriage penalty requires a few steps. In this case, the first step is to understand that, if you are married, the combined income of you and your spouse may push you both into a higher tax bracket than either of you would have been in as singles. This feature in the tax law creates a “penalty” for married couples, which gets more severe as the combined level of their incomes rises.
Second, it is important to note that legislation passed in 2003, which eliminated the marriage penalty for many people, is set to expire at the end of 2010. As such, the marriage penalty is scheduled to return for everyone in 2011.
Finally, if you are currently married or you are planning a wedding for the near future, there are options available to help you mitigate the potential impact of the marriage penalty.
Prior to 2003, if both spouses in a married couple had similar levels of income, their combined income would often push them into a higher tax bracket. As a result, they were effectively penalized for being married. The smaller the difference between what each spouse earned, the higher the marriage penalty. However, if one spouse earned a high salary, and the other did not, then they were not necessarily penalized. It was possible, though, for the marriage penalty to affect couples in all income brackets.
The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the impact of the marriage penalty by equalizing the standard deduction for singles and married couples and increasing the upper income limit of the 15 percent tax bracket for married couples filing jointly. As a result, the marriage penalty in the lower tax brackets was eliminated through 2010 because more married couples were able to remain within the 15 percent tax bracket.
The Marriage Penalty in 2010
If a household has only one source of income, it is generally beneficial for a married couple to go from filing as individuals to filing a joint return. This is because the phase-out thresholds for many tax credits and deductions increase for couples that file jointly. This generally allows for an overall tax benefit for single income households.
If both spouses earn income, there is a strong likelihood that they will be impacted by the marriage penalty. In 2010, the penalty occurs when each spouse earns over $68,650. In this case, the next dollar earned would move the married couple up to the 28 percent tax bracket. In contrast, a single person would remain in the 25 percent tax bracket for another $13,750 of income earned.
The penalty gets more severe for higher income couples. For example, in 2010, if each spouse earns $150,000, they would both be in the 28 percent tax bracket if they were unmarried. Once married, they are pushed up to the 33 percent tax bracket, whether they file a joint return or they file separately.
Please note that higher income taxpayers are not the only ones who are affected by the marriage penalty. For example, if an individual’s income is low enough, that person can often qualify for the earned income credit (a work incentive program that is intended to help low income families reduce their tax liability). Since married taxpayers must report their combined income, it is often more difficult for them to benefit from the earned income credit.
There a number of other tax and financial issues that are impacted (positively and negatively) by marriage. A few of those issues are as follows:
• Social Security benefits: The tax penalty also affects married people who receive social security benefits. The law often requires that a higher percentage of benefits be subject to income tax.
• Preferential estate-tax treatment: 2010 is a unique year for estate planning purposes (the estate tax lapsed at the end of 2009 and has yet to be reinstated for 2010, but is scheduled to return in 2011 at unfavorable rates). Nevertheless, for all years, regardless of the status of the estate tax, an individual may leave an unlimited amount to their spouse without generating any estate tax.
• Workplace healthcare coverage: Healthcare benefits to the spouses of employees are generally tax-free.
• Lower insurance rates: Married people frequently get a discount on auto insurance and often pay less for other types of insurance.
• Other areas: Differences between singles and married couples also exist in the rules governing capital losses, mortgage interest, and rental property losses, among others.
How to Prepare
Once married, one of the easiest ways to prepare is to request a consultation with us to determine whether your income tax withholding should be adjusted. Even if your adjustment will only affect the 4th Quarter of 2010, this can still make a significant impact on any potential tax liability due in April 2011.
If you are currently planning a year-end wedding, you may want to consider delaying your marriage until next year. We can help you determine whether the marriage penalty affects you, how much it will affect you and what, if anything, you can do to minimize its impact.