Married couples are faced with the decision of whether to file their federal tax returns jointly or separately, and this choice can have significant financial implications. While the Internal Revenue Service (IRS) generally encourages couples to file jointly, there are specific situations where filing separately might be a more advantageous financial strategy. In this blog post, we will explore several scenarios where it makes sense to file taxes jointly and where it makes sense to file taxes separately, focusing solely on the financial aspects of this decision.
Filing Taxes Jointly
Let’s start by considering a hypothetical example. Imagine a married couple consisting of one spouse earning $500,000 and the other spouse earning $100,000. If they opt to file their taxes jointly and take the 2023 Standard Deduction of $27,700, assuming no other above-the-line deductions like Traditional 401(k) plan contributions, Health Savings Account contributions, or Traditional IRA contributions, their taxable income would be $572,300. The U.S. tax system is progressive, with income being taxed at various rates, culminating in the highest marginal income tax rate of 37% for 2023, which applies to incomes starting at $693,750. By filing jointly, this couple manages to avoid the 37% tax bracket altogether. Based on the current tax code, their estimated federal tax liability would be $144,094.
Now, let’s explore the same scenario with the same income distribution but a different filing strategy: filing taxes separately.
The spouse earning $500,000 would show a taxable income of $486,150 after taking the standard deduction (limited to $13,850 if filing separately) and assuming no other deductions. However, filing separately results in a significant disadvantage: the 37% tax bracket begins at $346,875 of income. Consequently, approximately $130,000 of this spouse’s income would be subject to the highest federal tax rate, which would have been entirely avoided had they filed jointly.
For the spouse earning $100,000, their taxable income would be $86,150 after applying the standard deduction.
In summary, if the couple files jointly, they would owe approximately $144,094 in federal taxes. However, if they choose to file separately, their combined tax liability increases to $159,094.
In this example, the couple would save approximately $15,000 in federal taxes by filing jointly.
Filing Taxes Separately
Now, let’s explore a scenario where it makes sense to consider filing taxes separately instead of jointly. Suppose we have the same income distribution as before: one spouse earns $500,000, and the other earns $100,000. However, this time, the spouse earning $100,000 has a substantial student loan balance.
In order to minimize their student loan payments, they could contemplate filing taxes separately. Certain student loan repayment programs, such as SAVE, consider only the income of the spouse with student loans when calculating payments if they file separately.
In this case, let’s assume that by filing separately, the spouse with the $100,000 income can maintain a student loan payment of approximately $500 per month. If both spouses were to file jointly, and both incomes were used in the calculation, the student loan payment could surge to as high as $4,000 per month, depending on factors like interest rates and the loan term. This substantial difference of $3,500 per month in payments, totaling $42,000 per year, outweighs the $15,000 tax savings the couple would enjoy by filing jointly.
This strategy could be particularly beneficial if the spouse with the $100,000 income is pursuing a student loan forgiveness program and aims to keep their monthly payment as low as possible to maximize the eventual forgiven balance. In such cases, filing separately would likely be a prudent financial decision.
In conclusion, before making a decision on whether to file federal tax returns jointly or separately, it is advisable to consult with a tax and financial advisor who is knowledgeable about your unique financial circumstances and can help you make the most informed choice. Ultimately, the decision should align with your financial goals and obligations.
Disclosure
Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.
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This content has been prepared for general information purposes only and is intended to provide a summary of the subject matter covered. It does not purport to be comprehensive or to give advice. The views expressed are the views of the writer at the time of issue and may change over time. This is not an offer document, and does not constitute an offer, invitation, investment advice or inducement to distribute or purchase securities, shares, units or other interests or to enter into an investment agreement. No person should rely on the content and/or act on the basis of any matter contained in this document. The tax and estate planning information provided is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
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