By Grace S. Yung, CFP
With tax season now in full swing, you may be wondering how the Supreme Court’s marriage-equality ruling affects you. This ruling was passed in 2015, but if you’re newly married and wondering how things have changed, married same-sex couples can now take advantage of various deductions and retirement-planning strategies that were previously only available to opposite-sex married couples.
The ruling also makes all married couples subject to the same filing requirements. With that in mind, it is important to be sure that you and your spouse are getting the most benefit possible, both before and after retirement.
What Is the Best Way to File Your Tax Return?
Just like with investing, all situations are different, so there is no one-size-fits-all best strategy for filing your annual tax return. However, there are many more options that can be accessed now, primarily for married LGBT couples.
For instance, same-sex married couples are now required to file their federal tax returns (and state returns, if applicable) using the filing status of either “married filing jointly” or “married filing separately.”
If you file jointly, you may collectively end up in a higher tax bracket, as well as reduce some potential tax deductions. But you may also be able to take advantage of certain deductions that were not previously available to you. For example, as a married couple, the higher your combined tax bracket is, the more you may be able to deduct your Traditional IRA contribution—at least up to a certain point.
For instance, if you are married and filing jointly, and you are also covered by a retirement plan through your employer, there is an upper adjusted-gross-income limit of $119,000 (in 2017), beyond which you cannot deduct your traditional IRA contribution. If you file as “married filing separately” or as a head of household, the maximum income amount can differ.
Investing in an IRA
Investing in an Individual Retirement Account, or IRA, may also provide you with certain tax incentives, due to the tax-advantaged manner in which your funds accrue, as well as with the money going in or the money coming out in retirement, depending on which type of IRA you have. (You don’t have to choose just one or the other; many investors have both.)
• Traditional vs. Roth
The first step in taking advantage of tax-related IRA benefits is to understand how these accounts work. For example, with a Traditional IRA, most people are allowed to deduct their contributions going in. The gains inside of the account are allowed to grow tax-deferred, meaning that you won’t owe tax on the growth of your Traditional IRA funds until the time of withdrawal. If your contributions go into a Traditional IRA pre-tax, 100 percent of your withdrawals will be taxed at the time you make your withdrawals.
Alternatively, contributions go into a Roth IRA after-tax, so you may not deduct your contributions going in. But once they are in the account, they are not only allowed to grow free of taxation, but at the time of withdrawal, all Roth IRA funds come out tax-free. This can be a tremendous advantage in retirement, as it allows you to make use of all your funds for living expenses, etc.
In order to contribute to a Roth IRA, you will need to meet certain income guidelines, based on your annual adjusted gross income and your filing status. For 2016 and 2017, these parameters are:
For both Traditional and Roth IRAs, there is a maximum amount that you can contribute each year. For 2016 and 2017, that amount is $5,500 if you are age 49 or younger, and $6,500 if you are 50 or over. It is important to note that this maximum annual contribution is the total that can be deposited, regardless of which type of IRA you have. So, if you have both types, you could split the deposit amount between the two, based on your particular goals.
It is also important to be careful about withdrawing your IRA money before you reach age 59½. This is because in most cases, you will be hit with an “early withdrawal” penalty from the IRS—in addition to the tax that you will owe on your Traditional IRA funds.
If you invest outside of an IRA account (for instance, in stocks or mutual funds in a personal investment account), you can also obtain certain tax advantages. As an example, by taking any losses and immediately reinvesting in another financial vehicle, you could deduct some or all of your loss for the current year, and possibly carry forward the rest of the loss in future years.
Contributions to a traditional IRA may be tax-deductible in the contribution year, with the tax due at withdrawal at whatever tax rate is then in effect. Withdrawals prior to age 59½ may result in a 10 percent IRS penalty tax, in addition to current income tax.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax-free as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59½, or prior to the account being opened for five years, whichever is later, may result in a 10 percent IRS penalty tax. Future tax laws can change at any time, and may impact the benefits of the Roth IRA tax treatment.
• Spousal IRA Contributions for LGBT Couples
Another benefit that is now afforded to LGBT couples is the allowable spousal IRA contribution. This means that a spouse who earns little or no income can make contributions to an IRA. Here, having a spousal IRA can increase the amount that is available in your IRA accounts, possibly enhancing your income-tax deductions, as well as the amount of income that you have for withdrawals in retirement.
• Considerations for LGBT Business Owners
If you and/or your spouse own a business, there are some additional tax-related strategies to be aware of. For example, if you haven’t set up a retirement savings plan for your company, you may want to do so in the weeks ahead.
Here, a Simplified Employee Pension, or SEP-IRA, may provide you with some added benefits in terms of saving for the future and reducing your taxable income. A SEP-IRA can essentially provide you with benefits similar to a Traditional IRA, but the amount that you can contribute each year can be substantially higher. For instance, in 2016, you can contribute the lesser of 25 percent of your compensation or $53,000. (For the 2017 tax year, you may be able to contribute the lesser of 25 percent of compensation or $54,000.).
These plans allow you to deduct the contributions you make for your employees on your company’s tax return. A SEP-IRA can also offer you a flexible way to vary the employer contributions every year, from 0 percent to a maximum of 25 percent of compensation.
Married couples can have some advantages over non-married partners when it comes to SEP-IRA accounts. For instance, if a SEP-IRA owner passes away prior to age 70½, his or her spouse may be able to transfer the SEP assets into a new or existing IRA account of their own. They may also transfer the assets into an Inherited IRA account that is held in the decedent’s name. It may also be possible to take a lump-sum distribution from the account. While there will be income tax due on the entire amount of this lump sum, a 10 percent IRS early-withdrawal penalty will not apply—even if the surviving spouse is under age 59½.
While a non-married partner can also take advantage of these options, if they open an Inherited IRA, distributions must begin no later than December 31 of the year that the account holder passed away. As an alternative, the surviving partner must completely exhaust the account within five years.
SEP-IRA plans can be established by a number of business types, including sole proprietors, partnerships, corporations, and S-corporations. And, unlike most other types of retirement plans, a SEP-IRA can be established as late as the due date of your company’s tax filing, which is typically April 15, including extensions. This time frame also applies to making contributions into the plan for the previous year.
Planning Ahead for the Future
Because people are living longer now, ensuring that you have enough income to last for many years in retirement is essential. It can also be advantageous, and necessary, to provide for a surviving spouse—especially if he or she will be dependent on some or all of your retirement income for their future living expenses.
While you may not yet be close to your retirement years, it’s never too early to become knowledgeable about the future Social Security benefits that you are eligible for, as it can help with your overall retirement-planning strategy. Also, depending on whether or not you plan to continue working while receiving your Social Security benefits, you could be required to pay tax on some of your Social Security benefits.
• Social Security Benefits for Same-Sex Couples
As it stands now, same-sex couples are eligible for both Social Security spousal and survivor benefits. This means that a non-working spouse is now entitled to at least half of the Social Security retirement-income benefit of a working spouse. It also means that if your spouse passes away, you would be able to start receiving either your or your spouse’s Social Security retirement benefits, whichever one is higher.
In the case of Social Security, married same-sex spouses have another advantage that was previously only available to opposite-sex spouses—the “maximization” of your retirement-income benefits. This means that the higher-earning same-sex spouse may want to postpone the start of his or her Social Security retirement benefits in order to take advantage of a higher monthly amount down the road. For each year that you wait beyond your normal retirement age to collect, you can get an 8 percent “delayed income credit,” up to age 70. Doing so can provide you with more income in the future, as well as a higher income amount for a surviving spouse.
For example, if one spouse is at full retirement age and taking his or her full Social
Security benefit, and the other spouse is at least age 62 (which is the youngest age that you can start taking Social Security retirement benefits), the 62-year-old spouse can take a Social Security spousal benefit, continue to receive this benefit through his or her own full retirement age, and then switch over to taking their own Social Security benefit at age 70, when this benefit’s dollar amount has been increased by delayed retirement credits of 8 percent per year.
Also, if you and your spouse expect to be receiving pension income in retirement, there may also be pension-continuation benefits that are available to a surviving spouse now. In order to ensure that this income stream will continue, you will likely need to set up a reduced pension income with spousal continuation.
• Estate Planning Advantages for LGBT Spouses
If you’re married, planning ahead for the future with a good, solid estate plan can make sense too—and doing so can also provide you and your spouse with benefits that have not been available in the past.
For instance, same-sex married couples can now take advantage of the unlimited amount of assets that may be transferred to a surviving spouse upon the death of the first, without having to incur the federal estate tax.
In addition, one spouse is now allowed to make a gift or transfer property to a spouse, without being hit with federal income or gift taxes. And, any estate-tax and/or gift-tax exemptions that are unused may also now pass on to a same-sex surviving spouse.
The Bottom Line
As with any couple, discussions about money matters can either be beneficial or a source of friction. Because there have been numerous changes—particularly in terms of retirement benefits and taxes—that affect the LGBT community, it could be that much more important that you work with an advisor who is experienced in financial planning, as well as in LGBT issues.
Personal finance-related questions may be emailed to [email protected].
Grace S. Yung, CFP, is a certified financial planner practitioner with experience in helping domestic partners plan their finances since 1994. She is a principal at Midtown Financial LLC in Houston and was recognized as a “Five-Star Wealth Manager” in the 2014 September issue of Texas Monthly.