Friday, March 11, 2011

Can Same-Sex Couples Finally File Jointly?

Last month, the Obama Administration announced it would no longer fight constitutional challenges to the Defense of Marriage Act (DOMA) by same-sex couples who are legally married under state law
However DOMA is still on the books and must be enforced by the Feds (at least theoretically) until it is amended, repealed, or overturned in the courts. That may not happen anytime soon. House Speaker John Boehner has said he would initiate Congressional action to defend DOMA .
Trying to make sense of this muddled situation is difficult, but here is my take: Expect the government to half-heartedly say the DOMA rules still apply to legally married same-sex couples until the rules are challenged in court. At that point, the White House will punt. I doubt the Republicans can do anything to change that as long as Obama is president.
Now for the question of the day: assuming my analysis is correct, what impact (if any) does the administration's new DOMA position have on a legally married same-sex couple's federal tax situation? Before answering, let's briefly review why it matters.

Impact of being married (for tax purposes)

From a tax perspective, DOMA is important because it says same-sex couples who are considered married under state law are not considered married for federal tax purposes. With one big exception, the federal tax rules generally treat married folks better than singles. Here are the specifics.
In the scenario where one spouse earns most or all of the income and it is a healthy amount, being allowed to file a joint Form 1040 will cut the couple's federal income tax bill. That is because more of the higher-earning spouse's income gets taxed at lower rates and because married couples are entitled to bigger standard deductions than singles. This is the so-called "marriage bonus" in action.

Advantage: Tax-free employer benefits
When you are considered married for federal tax purposes, your spouse can receive certain tax-free benefits from your employer. The two most common examples are tax-free health insurance and tax-free payouts from flexible spending arrangements (FSAs).

Advantage: Better treatment for inherited retirement account balances
Another benefit for federal tax purposes is that your surviving spouse can roll over qualified retirement plan balances inherited from you into his or her own IRA. The surviving spouse is not required to start taking annual required minimum distributions (RMDs) from the rollover IRA until after he or she turns 70½. In contrast, when a non-spouse inherits a qualified retirement plan balance and transfers it to an IRA, he or she will usually have to start taking RMDs sooner and in larger amounts. Since RMDs are taxable, spouses are allowed to collect more tax-deferral benefits than non-spouses.
When you are considered married for federal tax purposes, your surviving spouse also can roll over IRA balances inherited from you into his or her own IRA. Once again, the RMD rules that apply in this situation allow spouses to collect more tax-deferral benefits than non-spouses.

Advantage: Better gift and estate tax rules
When you are considered married for federal tax purposes, you can make unlimited gifts to your spouse while you are still alive without any federal tax consequences (assuming your spouse is not a non-resident alien). When you die, you can leave your surviving spouse an unlimited amount free of any federal estate tax, thanks to the so-called unlimited marital deduction privilege (assuming your spouse is a U.S. citizen).
If you die in 2011 or 2012, you also can leave any unused federal estate tax exemption to your surviving spouse. That way, your spouse will have a bigger estate tax shelter if he or she also dies (after you) in 2011 or 2012. While federal gift and estate tax issues are not a big concern for most folks (thanks to the current $5 million gift and estate tax exemptions), wealthy couples who are considered married for federal tax purposes still have big advantages over those who are not.

Disadvantage: "Marriage penalty" can apply
The one big disadvantage of being considered married for federal tax purposes occurs when both spouses earn healthy incomes. In this scenario, a married couple can wind up with a bigger federal income tax bill than if they were single. This is the so-called "marriage penalty" in action. So a same-sex couple in this situation can actually benefit from being considered unmarried for federal tax purposes.

Have your tax-filing options changed?

I don't think so. Because DOMA is still the law of the land (however weakly it might be enforced), a married same-sex couple is still considered unmarried for federal tax purposes. Therefore, for 2010, I advise same-sex married individuals to file separate federal returns as singles. Then to protect your tax position in the event that DOMA is overturned, consider filing an amended joint return for 2010 using Form 1040X. You also can consider filing amended joint returns for earlier tax years that are still "open" (a year is generally "open" for up to three years after the date you filed your Form 1040 for that year). Talk to your tax pro about the advisability of filing amended returns. The potential tax savings may or may not be worth the trouble.

The last word

Some tax pros may disagree with my conservative take on your tax-filing options. Fair enough, because we are all on shaky ground here. That said, you certainly won't be charged any extra taxes or penalties if you follow my advice. Finally, one thing is completely clear: Nothing has changed for same-sex couples who are not legally married under state law. They must continue to file their federal returns as singles -- period.