I always assumed that filing taxes jointly as a married couple was always and without exception the best strategy… but you know what they say about assumptions. It turns out that this is NOT the case for at least some high-earning couples out there and I’m going to lay it out in this detailed post.
The intent of this post is NOT to vilify the institution of marriage or to denigrate the sincerity of commitment or love. Rather, this post is utilitarian–devoid of emotion or judgement! My sole intent is to provide a non-intuitive view that there may actually be a real tax cost to marriage. It’s time to be disabused of the misunderstood tax codes related to marriage.
Federal Income Tax Marriage Penalty
The idea of a “marriage penalty” in the federal income tax code is a well-known concept and has been studied for decades as legislation has provided a moving target to optimize tax strategy. The issue has been studied by The Urban-Brookings Tax Policy Institute. They have even created a free online calculator.
For illustrative purposes, let’s work through one example though. Imagine that you are married with two dependent children and you both make $250K in taxable income. Using this calculator, you are paying $7,528 MORE in federal income taxes because you are married.
Let’s break it down though. WHY are you paying that much more?
Health Savings Accounts
Health Savings Accounts (HSAs) allow pre-tax contributions to an account earmarked for only healthcare expenses. These contributions are sometimes referred to as a ‘stealth IRA’ because they can even be invested and tax-free gains will compound on this pre-tax income. Married couples can contribute up to the maximum of $7100 in 2020. However, domestic partners can EACH contribute up to $7100 for a total of $14100 in pre-tax HSA contributions! Depending on your marginal tax rate, this could result in as much as $3550 in tax savings.
Mortgage Interest Deduction
Unmarried, cohabitating couples could potentially double their mortgage interest deduction. As you probably know, the interest paid on your primary or even secondary residence mortgage can be fully deducted and you typically receive a Schedule 1098 each year detailing this interest paid. However, there has always been a maximum loan limit and this recently decreased to $750,000 due to the Tax Cuts and Jobs Act of 2017.
As detailed in this Forbes article, a 9th Circuit Appeals Court ruling in 2016 decided that the interest deduction should be applied to each TAXPAYER and NOT each RESIDENCE. Therefore, if you have a $1.5 million mortgage in both you and your partner’s names, and you each pay an equal part of the mortgage interest, you can both take the maximum deduction of interest from the $750,000 half of the loan. H&R Block even explains how to do it properly if you only receive one Schedule 1098.
These savings are dependent on how much interest you pay on your mortgage(s), but hypothetically, you could end up with an extra $30,000 or more in deductible income in the first year of a mortgage and this would almost certainly result in several thousands of dollars in tax savings.
If partners have a significant disparity between their incomes, different scenarios of claiming dependents should be considered. Although married couples claim dependents together, unmarried partners could see significant benefit by splitting up the dependents or grouping them all together under one partner’s taxes.
For example, the Child Tax Credit phases out above an adjusted gross income of $400,000 for married couples. You can estimate your family’s credit using the IRS worksheet. However, let’s say your adjusted gross income was $500,000, but you made $300,000 and your spouse made $200,000. If you have 2 children, you would not qualify for the child tax credit at all by filing as a married couple! However, if you were unmarried and your partner claimed both of them, they would qualify for a $4000 tax credit–the full amount of $2000 per child!
This credit could obviously represent significant tax savings if a couple remains unmarried, determines the best strategy for claiming dependents, and reduces their adjusted gross income with above-the-line deductions.
Since you have been actively investing your portfolio in equities, options and cryptocurrency, you actually have to worry about capital gains and the relatively esoteric ‘wash sale‘ rule. Read about it if you are unfamiliar with this issue.
It turns out that although a wash sale is triggered if you repurchase the equity in your spouse’s account, it DOES NOT count if it’s your partner. Therefore, you could hypothetically harvest losses in your personal account and re-enter those same equity positions in your partner’s account. This saves you the 30 day waiting period which could cost you significant gains if for example the equity rebounds quickly in that time or pays a dividend.
The IRS is one-step ahead
It is almost guaranteed that for every possible tax saving strategy that can be devised, many have already tried. When people get creative with their taxes, the smart ones rely on an accountant or a tax attorney to keep them out of jail. For example, couples have already attempted year-end, temporary divorces and a re-marriage in January so that they could save on taxes by filing separately. The IRS has already ruled against this:
If you and your spouse obtain a divorce in one year for the sole purpose of filing tax returns as unmarried individuals, and at the time of divorce you intend to remarry each other and do so in the next tax year, you and your spouse must file as married individuals.IRS Publication 504
And so as a warning, IF you are already married and plan on utilizing this strategy for the future, I would strongly suggest consulting an expert to help you navigate these dangerous waters. If you are not yet married, then this strategy will be much easier to apply. However, “I don’t want to get married because I could save a lot of taxes,” is definitely going to be quite the conversation starter and you might want to save it for at least the 2nd date.