Dear Clients and Friends:

An often-asked tax question is whether you and your spouse should file a joint tax return or separate returns. As is often the case with tax questions, the answer depends on your particular tax picture.

In general, your decision will depend upon which filing status results in the lowest tax. But bear in mind that, if you and your spouse file a joint return, each of you is jointly and severally liable for the tax on your combined income, including any additional tax that IRS assesses, plus interest and most penalties. This means that IRS can come after either of you to collect the full amount. Although there are provisions in the law that offer relief from joint and several liabilities, each of those provisions has its limitations. Thus, even if a joint return results in less tax, you may choose to file a separate return if you want to be certain of being responsible only for your own tax.

In most cases, filing jointly offers the most tax savings, particularly where the spouses have different income levels. The "averaging" effect of combining the two incomes can bring some of it out of a higher tax bracket. For example, for 2002, if one spouse has $75,000 of taxable income and the other has just $15,000, filing jointly instead of separately can save over $1,500 in taxes.

Note that filing separately doesn't mean you go back to using the "single" rates that applied before you were married. Instead, each spouse must use the "married filing separately" rates. These rates are based on brackets that are exactly half of the married filing joint brackets but are still less favorable than the "single" rates. This means the "marriage penalty" (which requires some spouses to pay at a higher tax rate on the same total income than they would pay if each were single) isn't eliminated by filing separate returns. Note that although you may have heard that Congress has acted to provide relief from the marriage penalty in the tax rates, those changes don't begin to apply (phase-in) until 2005, and even after fully phased-in (in 2008) don't provide a complete solution.

There is a potential for tax savings from filing separately, however, where one spouse has significant amounts of medical expenses, casualty losses, or "miscellaneous itemized deductions." These deductions are reduced by a percentage of adjusted gross income (AGI). Medical expenses are deductible only to the extent they exceed 7.5% of AGI, and casualty losses must exceed 10% of AGI. Miscellaneous itemized deductions, which include a variety of deductions such as investment expenses (other than investment interest), non-reimbursed employee expenses, and tax return preparation costs, are deductible to the extent their combined total exceeds 2% of AGI (often referred to as a "2% floor").

If these deductions are isolated on the separate return of a spouse, that spouse's lower (separate) AGI, as compared to the higher joint AGI, can result in larger total deductions. For example, if one spouse has $7,000 in medical expenses and joint income is $90,000, then only $250 is deductible on a joint return, because 7.5% of $90,000 is $6,750 (and $7,000 - $6,750 = $250). But if the income of the spouse with the medical expenses is separately only $15,000, the deduction increases to $5,875 on a separate return, because 7.5% of $15,000 is only $1,125 (and $7,000 - $1,125 = $5,875).

On the other hand, the amounts you claim as a deduction for exemptions and for certain itemized deductions, including miscellaneous itemized deductions, are phased out (i.e., reduced) once your AGI goes above a certain threshold, depending upon your filing status. The AGI threshold at which phase-out of exemptions and itemized deductions begins is higher for joint returns than for separate returns. For example, in the case of exemptions, the threshold in 2002 for joint returns is $206,000 as compared to only $103,000 for separate returns. Thus, if you file a separate return, your deduction for exemptions is phased out if your AGI exceeds $103,000. But if you and your spouse file a joint return, your deduction for exemptions doesn't begin to phase out until your AGI exceeds $206,000. This means that a phase-out, which might be suffered on a separate return, may be avoided if you and your spouse file a joint return. The tax savings at stake will vary depending on how many exemptions are claimed and your income levels. The required exemption and itemized deduction phase-outs are scheduled to be reduced beginning in 2006. But until the phase-out rules are completely eliminated (in 2010), they must be considered in determining whether to file a joint or separate return.

Other tax factors may point to the advisability of filing a joint return. For example, the child and dependent care credit, adoption expense credit, Hope and Lifetime learning credits, and the deduction for higher education expenses are available to a married couple only on a joint return. And you can't take the credit for the elderly or the disabled if you file separate returns unless you and your spouse lived apart for the entire year. Nor can you deduct qualified education loan interest unless a joint return is filed. Also, you may not be able to deduct contributions to your IRA if either you or your spouse was covered by an employer retirement plan and you file separate returns. Nor can you exclude adoption assistance payments or any interest income from series EE savings bonds that you used for higher education expenses if you file separate returns.

In addition, social security benefits may be more heavily taxed to a couple that files separately. The benefits are tax-free if your "provisional income" (your adjusted gross income with certain modifications plus half of your social security benefits) doesn't exceed a "base amount." The base amount is $32,000 on a joint return, but zero on separate return (or $25,000 if the spouses didn't live together for the entire year).

The decision you make for federal income tax purposes may have an impact on your state or local income tax bill, so the total tax impact has to be compared. For example, an overall federal tax saving by filing separately might be offset by an overall state tax increase, or a state tax saving might offset a federal tax increase.

Unfortunately, I can't give you any hard and fast rules of thumb for when it pays to file separately. The tax laws have grown so complex over the years that there are often a number of different factors at play for any given situation. However, there is one approach guaranteed to come up with the correct decision. We can simply calculate your tax bill both ways: jointly and separately. Then the approach that leads to overall tax savings could be used.

If you have any questions about this topic or any other please feel free to call 315-363-3338 for an appointment.

Sincerely,

G. William Hatfield
Certified Public Accountant
Certified Financial Planner