Last week we discussed the "marriage penalty" and how it may impact you as a taxpayer. The obvious next question is: "Should my spouse and I file using the married-separate filing status to avoid the marriage penalty?"

As is often the case with tax questions, there is no clear-cut answer. It depends on your individual tax situation.

In general, your decision will depend on which filing status results in the lowest tax. But, while that may seem obvious, there is one very important consideration you should take into account: If you and your spouse file a joint return, you are jointly and severally liable for the full amount of tax and any interest or penalty due. This means that if your spouse decides to take the cash out of the bank and run away to Costa Rica, you could be stuck with the total tax liability. Therefore, regardless of which method results in less tax, you may choose to file a separate return if you want to ensure you're only responsible for paying 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, if one spouse has $75,000 of taxable income and the other has just $15,000, filing jointly can save about $1,500 in taxes versus filing separately.

But, remember 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 jointly" brackets, but are still less favorable than the "single" rates. This means that the "marriage penalty" can't necessarily be eliminated simply by filing separate returns.

The Upside

There is a potential for tax savings from filing separately — when one spouse has significant medical expenses, casualty losses, or miscellaneous itemized deductions. These deductions are reduced by a percentage of adjusted gross income (AGI). Medical expenses, for example, are deductible only to the extent they exceed 7.5% of AGI, and only the portion of casualty losses that exceeds 10% of AGI is deductible. 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 only 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 the couple's 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 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).

The Downside

On the other hand, the amounts you can claim for exemptions and itemized deductions, including miscellaneous itemized deductions, are phased out (i.e., reduced) once your AGI goes above a certain limit, depending on your filing status. The limit is higher for joint returns than for separate returns.

For example, in the case of the phase-out of personal exemptions, the AGI threshold in 2000 for joint returns is $193,400, but only $96,700 for separate returns. Thus, if you file a separate return, your deduction for exemptions is phased out if your AGI exceeds $96,700. But if you and your spouse file a joint return, your deduction for exemptions doesn't begin to phase out until your AGI exceeds $193,400.

Example: Jack and Jill are married. Jack's annual income is $30,000. Jill's annual income is $110,000. If they file a married-joint return, their combined AGI would be $140,000 and they would be well under the $193,400 threshold for personal exemption phase-out. But, if they elect to file married-separate returns, Jack will do fine, but Jill will get nicked for additional taxes due to a phase-out of her personal exemption. In this case, it would likely be best for Jack and Jill to file jointly.

The amount of tax savings at stake will vary depending on how many exemptions are claimed and your income levels. There are also similar phase-out rules that reduce itemized deductions that may be affected by the "joint or separate" filing decision.

Wave Good-bye (To Many Deductions and Credits)

There are many other tax factors that might impact your decision to file separately. For example:

• The child and dependent care credit, adoption expense credit, and Hope and Lifetime learning credits are only available to a married couple filing a joint return.
  
• 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.
  
• You cannot deduct qualified education loan interest unless a joint return is filed.
  
• You may not be able to deduct contributions to your IRA if either you or your spouse was covered by an employer's retirement plan and you file separate returns.
  
• A Roth IRA contribution or conversion is virtually out of the question.
  
• You cannot 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.
  
• Social Security benefits are, in some instances, more heavily taxed for a couple filing separately. The benefits are tax-free where modified AGI does not exceed $32,000 for a joint return, but the base amount is zero on a separate return.
  

Bottom Line

The decision you make for federal income tax purposes may have an impact on your state income tax bill, so the total tax impact has to be compared. For example, an overall federal tax savings by filing separately might be offset by an overall state tax increase, or vice versa. Obviously, this will depend on the laws of your state, but it is certainly an issue that must be considered before making your final decision.

Unfortunately, I can't give you any hard-and-fast rules 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. The only real way that you can determine exactly which filing status is best for you is to "run the numbers," prepare your tax returns using both methods, and make your decision. It can be a difficult process. If you use computer tax programs, preparing and comparing these returns is less daunting if you know the law and apply it correctly.

Finally, those of you residing in "community property" states have even more issues to deal with when trying to separate joint income and assets to prepare a married-separate tax return. We'll discuss those issues in greater detail next week.

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2000: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

May 19, 2000

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