Married? Thinking about NOT filing a joint return with your spouse? Most likely, you will utilize the ‘married filing separate’, or MFS, filing status. With this, you must be aware that there are special tax codes involved that married individuals CANNOT benefit by filing as MFS. Dagley & Co. describes some of the most frequent issues we’ve encountered when making the choice of the MFS filing status. (Please note, all dollar amounts are those for 2017)
Joint & Several Liability – When married taxpayers file joint returns, both spouses are responsible for the tax on that return. What this means is that one spouse may be held liable for all the tax due on a return, even if the other spouse earned all the income on that return. In some marriages, this becomes an issue and causes the spouses to decide to file separately. In other cases, especially second marriages, the couple may want to keep their finances separate. Unless all the income, exemptions, credits and deductions are divided equally, which usually happens in community property states, this generally causes the incomes to be distorted and could easily push one of the spouses into a higher tax bracket and create a greater combined tax than filing jointly. Being in a separate property state, where each spouse claims their own earnings, can also create an uneven allocation of income and a higher tax bracket for one of the spouses.
Exemptions – Taxpayers are allowed a $4,050 tax exemption for each of their dependents. However, the $4,050 allowance cannot be divided between the MFS filers, so only one of the filers can claim a dependent’s exemption, and where there are multiple dependents, the spouses would need to allocate the exemptions between them.
Itemizing Deductions – To prevent taxpayers from filing MFS and one spouse taking advantage of itemized deductions and the other utilizing the standard deduction, the tax regulations require both to itemize if one of them does.
Social Security Income – When filing a joint return, Social Security (SS) income is not taxable until the modified AGI (MAGI) – which is regular AGI (without Social Security income) plus 50% of the couple’s Social Security income plus tax-exempt interest income and plus certain other infrequently encountered additions – exceeds a taxable threshold of $32,000. However, for married taxpayers who have lived together at any time during the year and are filing married separate, the threshold is zero, generally making more of the Social Security income taxable.
Section 179 Deduction – Businesses can elect to expense, instead of depreciate, up to $510,000 of business purchases, generally including equipment, certain qualified leasehold property and off-the-shelf computer software. The $510,000 cap is reduced by $1 for every $1 that the qualifying purchases exceed $2,030,000 for the year. Married taxpayers are treated as one taxpayer for purposes of the Section 179 expense limit. Thus, they generally must split the limit equally unless they can agree upon and elect an unequal split.
Special Passive Loss Allowance – Passive losses are generally losses from business and rental activities in which a taxpayer does not materially participate. Those losses are not allowed except to offset income from other passive activities. Rental property is an example of a passive activity, and for lower-income taxpayers, a special allowance permits taxpayers who are actively involved in the rental activity to currently deduct a loss of up to $25,000 if their AGI does not exceed $100,000. That $25,000 special loss allowance phases out by 50 cents for each $1 of AGI over $100,000 and is completely eliminated when the AGI reaches $150,000. When filing separately, this special allowance is not allowed unless the spouses live apart the entire year, and then the allowance is reduced to $12,500 each.
Traditional IRA Deduction Phase-Out – If a married taxpayer filing jointly is participating in a qualified employer pension plan, the deductibility of a traditional IRA contribution is phased out ratably for an AGI between $99,000 and $119,000. If the taxpayers file married separate, the phase-out begins at $0 if the taxpayer participates in their employer’s plan, and when the AGI reaches $10,000, no traditional IRA deduction is allowed. So little, if any, IRA deduction will be available to such an MFS filer.
Roth IRA Contribution Phase-Out – Taxpayers may choose to contribute to a non-deductible Roth IRA. However, Roth IRA contributions are ratably phased out for higher-income married filing jointly taxpayers with an AGI between $186,000 and $196,000. For a married taxpayer filing MFS status, that AGI phase-out range drops to $0 through $9,999, virtually eliminating the possibility of a Roth contribution.
Coverdell Education Accounts – Taxpayers are allowed to contribute up to $2,000 per beneficiary to a Coverdell education savings account annually. However for joint filers, the amount that can be contributed ratably phases out for AGIs between $190,000 and $220,000. For married filing separate taxpayers, the phase-out is half that amount, from $95,000 to $110,000.
Education Tax Credits – Taxpayers are allowed a tax credit, called the American Opportunity Tax Credit, of up to $2,500 per family member enrolled at least half-time in college for the cost of tuition and qualified expenses. This credit phases out ratably for higher-income married taxpayers filing jointly with an AGI between $160,000 and $180,000.
There is a second higher-education credit called the Lifetime Learning Credit, which provides a credit of up to $2,000 per family. This credit also phases out ratably for higher-income married taxpayers filing jointly with an AGI between $112,000 and $132,000.
However, neither credit is allowed for married filing separate taxpayers.
Higher Education Interest – Taxpayers can take a deduction of up to $2,500 for student loan interest paid on higher-education loans. Like other benefits, it is phased out for higher-income married taxpayers filing jointly, in this instance when the AGI is between $135,000 and $165,000. It is not allowed at all for taxpayers filing as married separate.
Education Exclusion For U.S. Savings Bond Interest – Although not frequently encountered, interest from certain U.S. Savings Bonds can be excluded if used to pay higher-education expenses for the taxpayers and their dependents. The exclusion phases out for married taxpayers with an AGI between $117,250 and $147,250. This deduction is not allowed at all when filing married separate.
Premium Tax Credit – For married taxpayers who qualify for the PTC (health insurance subsidy) under Obamacare, if they file married separate, they may be required to repay the subsidy.
Earned Income Tax Credit – This is a refundable tax credit that rewards lower-income taxpayers for working and can be as much $6,318 for families with three or more qualifying children. Taxpayers filing as married separate are not qualified for this credit.
Child Care Credit – If both spouses work and incur child care expenses, they qualify for the child care credit. However, for those married filing separate, the credit is not allowed.
Halved Deductions & Credits – Many of the deductions and credits allowed to a married couple filing jointly are cut in half for the married filing separate filing status. They include:
- Standard Deduction
- Standard Deduction Phase-Out
- Alternative Minimum Tax Exemptions
- Alternative Minimum Tax Exemptions Phase-Outs
- Child Tax Credit Phase-Out
Head of Household Filing Status – Where a married couple is not filing jointly, one or both spouses may qualify for the more beneficial Head of Household (HH) filing status rather than having to file using the MFS status. A married individual may use the HH status if they lived apart from their spouse for at least the last six months of the year and paid more than one-half of the cost of maintaining his or her home as a principal place of abode for more than one-half the year of a child, stepchild or eligible foster child for whom the taxpayer may claim a dependency exemption. (A non-dependent child only qualifies if the custodial parent gave written consent to allow the dependency to the non-custodial parent or if the non-custodial parent has the right to claim the dependency under a pre-’85 divorce agreement.)
As you can see, there are a significant number of issues that need to be considered when making the decision to use the married filing separate status. And these are not all of them, but only the more significant ones. The filing status decision should not be made nonchalantly, as it can have significant impact on your taxes. Please contact Dagley & Co. for assistance in making that crucial decision.
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When it comes to saving for your children’s education, the tax code provides two primary advantages. We frequently get questions about the differences between the programs and about which program is best suited for a family’s particular needs.
The Coverdell Education Savings Account and the Qualified Tuition Plan (frequently referred to as a Sec 529 Plan) are similar; neither provides tax-deductible contributions, but both plans’ earnings are tax-free if used for allowable expenses, such as tuition. Therefore, with either plan, the greatest benefit is derived by making contributions to the plan as soon as possible—even the day after a child is born—so as to accumulate years of investment earnings and maximize the benefits. However, that is where the similarities end, and each plan has a different set of rules.
Coverdell Savings Accounts only allow a total annual maximum contribution of $2,000. The contributions can be made by anyone, including the beneficiary, so long as the contributor’s adjusted gross income is not high enough to phase out the allowable contribution. (The phase-out threshold is $190,000 for married contributors filing jointly and $95,000 for others.) Unless the beneficiary of the account is a special needs student, the funds must be withdrawn prior to age 30. The funds can be used for kindergarten through post-secondary education. Allowable expenses generally include tuition; room, board, and travel expenses required to attend school; books; and other supplies. Tutoring for special needs students is also allowed. Funds can be rolled over from one beneficiary to another in the same family. Although the funds can be used starting in kindergarten, the chances are that not enough of earnings will have been accumulated by that time to provide any significant benefit.
On the other hand, state-run Sec 529 plan benefits are limited to postsecondary education, but they allow significantly larger amounts to be contributed; multiple people can each contribute up to the gift tax limit each year. This limit is $14,000 for 2015, and it is periodically adjusted for inflation. A special rule allows contributors to make up to five years of contribution in advance (for a total of $70,000 in 2015).
Sec. 529 Plans allow taxpayers to put away larger amounts of money, limited only by the contributor’s gift tax concerns and the contribution limits of the intended plan. There are no limits on the number of contributors, and there are no income or age limitations. The maximum amount that can be contributed per beneficiary is based on the projected cost of college education and will vary between the states’ plans. Some states base their maximum on an in-state four-year education, but others use the cost of the most expensive schools in the U.S., including graduate studies. Most have limits in excess of $200,000, with some topping $370,000. Generally, once an account reaches that level, additional contributions cannot be made, but that doesn’t prevent the account from continuing to grow.
Which plan (or combination of plans) is best for your family depends on a number of issues, including education goals, the number and ages of your children, the finances of your family and of any grandparents or other relatives willing to help, and a number of other issues. For assistance in establishing education savings plans, please get in touch with us at Dagley & Co.
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If you’re smart enough to seek an advanced education (and/or help your children seek it for themselves), be smart enough to take advantage of its tax breaks! Going to college – and figuring out how to pay for it – can be stressful for students and their families. Congress has provided a variety of new tax incentives to help defray the cost of education. Some of these require long-term planning to become beneficial, while others provide almost immediate tax deductions or credits. The benefits may even cover vocational schools.
If your child is below college age, there are tax-advantaged plans that allow you to save for the cost of college. Although providing no tax benefit for contributions to the plans, they do provide tax-free accumulation; so the earlier they are established, the more you benefit from them.
- Section 529 Plans—Section 529 Plans (named after the section of the IRS Code that created them) are plans established to help families save and pay for college in a tax-advantaged way and are available to everyone, regardless of income. These state-sponsored plans allow you to gift large sums of money for a family member’s college education while maintaining control of the funds. The earnings from these accounts grow tax-deferred and are tax-free, if used to pay for qualified higher education expenses. They can be used as an estate-planning tool as well, providing a means to transfer large amounts of money without gift tax. With all these tax benefits, 529 Plans are an excellent vehicle for college funding. Section 529 Plans come in two types, allowing you to either save funds in a tax-free account to be used later for higher education costs, or to prepay tuition for qualified universities. For 2015, you can contribute $14,000 without gift tax implications (or $28,000 for married couples who agree to split their gift). The annual amount is subject to inflation-adjustment. There is also a special gift provision allowing the donor to prepay five years of Sec 529 gifts up front without gift tax.
- Coverdell Education Savings Account—These accounts are actually education trusts that allow nondeductible contributions to be invested for a child’s education. Tax on earnings from these accounts is deferred until the funds are withdrawn, and if used for qualified education purposes, the entire withdrawal can be tax-free. Qualified use of these funds includes elementary and secondary education expenses in addition to post-secondary schools (colleges). This is the only one of the educational tax benefits that allows tax-free use of the funds for below college-level expenses. A total of $2,000 per year can be contributed for each beneficiary under the age of 18. The ability to contribute to these plans phases out when the modified adjusted gross income is between $190,000 and $220,000 for married taxpayers filing jointly, and between $95,000 and $110,000 for all others.
- Education Tax Credits—Two tax credits, the American Opportunity Credit (partially refundable) and the Lifetime Learning Credit (nonrefundable), are available for qualified post-secondary education expenses for a taxpayer, spouse, and eligible dependents. Both credits will reduce one’s tax liability dollar for dollar until the tax reaches zero. The credit is not allowed for taxpayers who file Married Separate returns.
- The American Opportunity Credit—is a credit of up to $2,500 per student per year, covering the first four years of qualified post-secondary education. The credit is 100% of the first $2,000 of qualifying expenses plus 25% of the next $2,000 for a student attending college on at least a half-time basis. Forty percent of the American Opportunity credit is refundable (if the tax liability is reduced to zero). This credit phases out for joint filing taxpayers with modified adjusted gross income between $160,000 and $180,000, and between $80,000 and $90,000 for others.
- The Lifetime Learning Credit—is a credit of up to 20% of the first $10,000 of qualifying higher education expenses. Unlike the American Opportunity Credit, which is on a per-student basis, this credit is per taxpayer. In addition to post-secondary education, the Lifetime Credit applies to any course of instruction at an eligible institution taken to acquire or improve job skills. For 2015 this credit phases out for joint filing taxpayers with modified adjusted gross income between $110,000 and $130,000, and between $55,000 and $65,000 for others. The credit is not allowed for taxpayers who file Married Separate returns.
Qualifying expenses for these credits are generally limited to tuition. However, student activity fees and fees for course-related books, supplies, and equipment qualify if they must be paid directly to the educational institution for the enrollment or attendance of the student.
You may qualify for this credit even if you did not pay the tuition. If a third party (someone other than the taxpayer or a claimed dependent) makes a payment directly to an eligible educational institution for a student’s qualified tuition and related expenses, the student would be treated as having received the payment from the third party, and, in turn, pay the qualified tuition and related expenses. Furthermore, qualified tuition and related expenses paid by a student would be treated as paid by the taxpayer if the student is a claimed dependent of the taxpayer.
- Education Loan Interest—You can deduct qualified interest of $2,500 per year in computing AGI. This is not limited to government student loans and this could include home equity loans, credit card debt, etc., if the debt was incurred solely to pay for qualified higher education expenses. For 2015, this deduction phases out for married taxpayers with an AGI between $130,000 and $160,000 and for unmarried taxpayers between $65,000 and $80,000. This deduction is not allowed for taxpayers who file married separate returns.
We all know that a child’s success in life has a great deal to do with the education they receive. You cannot start the planning process too early. Please call Dagley & Co. if you would like assistance in planning for your children’s future education.
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