Although married couples are given certain tax and estate planning benefits not available to unmarried individuals, it isn’t all good news. Many high-earning couples find that their marginal tax rate increases after marriage – an effect known as the marriage tax penalty. The impact of a marriage tax penalty – or marriage tax bonus – will vary for each couple. Tax Foundation reports that a marriage penalty could be up to 12% of income. Before you call off the wedding, first understand what the marriage tax penalty is and what strategies you can use to plan for it.
Marriage tax penalty explained
The U.S. uses a marginal tax system where your tax rate is determined by your taxable income; as your income grows so does your marginal income tax rate. The system often forces couples who are married and filing jointly to pay more in taxes than they would if they were single and filing individual tax returns.
The way the tax brackets are structured, a single filer’s income band attached to a tax rate is not simply doubled for couples filing jointly. For example, in 2016, a single filer can have taxable income up to $91,150 without exceeding the 25% marginal income tax rate. For married couples filing jointly, their combined taxable income cannot exceed $151,900 if they plan to stay within the same 25% marginal tax bracket. In short, the tax code becomes more progressive for married filers, especially as taxable income increases.
Newlyweds may also find themselves suddenly hit with the Additional Medicare Tax. Single filers only are subject to the .9% Additional Medicare Tax if their taxable income exceeds $200,000; however for married taxpayers filing jointly, the threshold is only 25% higher: $250,000.
Two working people who earn the same amount are often surprised to move into a higher tax bracket upon doing their taxes for the first time as man and wife. Although there isn’t always much you can do to offset the impact from a potential marriage tax penalty, proper planning is necessary to ensure you’re using the strategies available – and not underpaying the government.
The marriage tax penalty and the marriage tax bonus
As explained previously, couples that earn roughly the same amount are more likely to receive the marriage tax penalty; however those who earn disparate incomes might be rewarded with the marriage bonus.
A marriage bonus most frequently occurs when a higher earning individual gets married to a person with much lower taxable income. The spouse with greater taxable income may be able to move into a lower marginal tax bracket due to their combined income. Keep in mind that while in aggregate the couple may pay less in taxes the year they marry when compared to the previous year, in this situation, it is very likely the lesser-earning partner will be bumped into a higher marginal tax rate after the marriage. Since not all married couples manage their finances alike, it is important to understand the impact in case a more equitable arrangement should be discussed.
Whether you’ll receive a marriage tax penalty or marriage tax bonus depends on a number of factors. (Outside of income, children are the next biggest difference maker.) There are plenty of free online tools available to estimate your impact, but the best advice is to consult a certified public accountant (CPA).
Strategies to plan for the impact
Increase contributions to tax-deferred accounts
With two incomes, a married couple might have more cash available to plan for other life goals in a tax-efficient way. For example, increasing your contributions to a qualified retirement plan will reduce your overall taxable income. Depending on your income and whether you’re covered by a plan at work, you may also be able to make tax-deductible contributions to an IRA. If one spouse does not work, you may be able to set up a spousal IRA, based on the working spouse’s earned income.
Review employer benefits
If both spouses are employed full time, it’s prudent to compare the benefit packages available. Health insurance plans and coverage costs vary between employers, and it often makes sense for a couple to use the same insurance. Other benefits like a flexible spending account and health savings account should also be considered to reduce your taxable income.
Reflecting your new marriage status on your W-4, but not altering the amount withheld in taxes each pay period, can often result in a large tax bill for April. And you may even have to pay a penalty for underpayment of your income taxes. A certified public accountant (CPA) can help you estimate your future tax bracket, expected tax liability, and whether quarterly payments should be made to the IRS.
Marriage has been known to change everything – for better or worse. Tax planning may not be at the top of your newlywed to do list, but it is something each couple should review before April. Learn more about how our wealth management program helps married couples with the transition.
By Caroline E. Coderre, CFP®, CDFA™