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Life Events and Taxes: A Complicated Combination

by
Gordon W. McNamee
on
9/29/2019
Life Events and Taxes: A Complicated Combination

Have you ever heard the phrase, “The more things change, the more they stay the same”? When it comes to your income taxes, their presence in your life may never change, but their details do when you go through significant life experiences. Marriages, divorces, births, deaths, and deciding to purchase a home are all life-altering milestones that — for better or worse — the IRS needs to know about. Each event can impact your tax liability in a big way. Let’s take a closer look.

Getting Married or Divorced

Marriage and divorce can both make a big difference in the amount you owe in taxes. This is because it changes your tax filing status.

Marriage

Whether you’re just got married or you’re about to, the Internal Revenue Service counts you as having been married for the entire year if you’re married as of December 31st. That means that neither of you are able to use the single filing status anymore; you have to choose between filing as married filing jointly (MFJ) and married filing single (MFS).

The first option — MFJ — adds both spouses’ incomes and deductions into one return, and doubles many of the threshold amounts for write-offs and phase-outs, as well as the amount you can claim for your standard deduction. Though this can work to your advantage, the combination of your two incomes also has a good chance of pushing you up into the next tax bracket.

Many couples get married and sit down to prepare their tax return, only to end up shocked by how much they owe for the previous year. The best way to prepare for the higher tax rate you’ll pay for the year that you’re married is to adjust your withholding as early in your wedding year as possible, to make sure that your employer is taking out the proper amount. The other thing you should do as early as possible is to notify the Social Security Administration of any name or address change for either partner.

Divorce

The complications evoked by marriage pale in comparison to what happens when you go through a divorce. Not only do you need to reverse your tax filing status, but you will also have additional considerations surrounding the division of assets and any spousal or child support that you are either paying or receiving. Divorced couples need to resolve the question of who claims the child as a dependent and who can take the various deductions and write offs associated with childcare and education. The points shown below address just a few of the taxation elements that should be addressed as part of the divorce process.

  • Alimony – As of the end of 2018, the ex-spouse who is responsible for paying alimony is no longer able to deduct those payments as an adjustment to gross income and the spouse who is receiving the support payments is no longer required to report the payments as income. Divorce agreements that were created and signed prior to December 31st, 2018 will be grandfathered into the previously existing rules.
  • Child Support — The IRS does not allow child support payments to be deducted by the paying parent and does not consider these payments income for the parent who receives the payments.
  • Child Dependency – Legally, whoever is awarded physical custody of a child automatically is awarded dependency too, with no consideration given to who is earning a higher income or providing greater financial support for the child. Dependency is an area that divorcing couples may choose to negotiate within the terms of the divorce, and the IRS provides a form that permits parents to assign dependency based on the terms that they agree to.
  • Child Tax Credit – Married and unmarried taxpayers who are parents are permitted a $2,000 federal child tax credit, $1,400 of which is refundable, for each child under 17, and that credit is available to divorced parents too. For single parents who earn a high income, the credit starts to phase out at income levels of $200,000. The child tax credit is automatically expected to be taken by the parent who claims the child as a dependent on their tax return.
  • Filing Status – Married couples who are in the midst of divorcing but who are still formally married by year end have a few options available to them when it comes to filing taxes. They can continue to file jointly; they can filed as married filing separately; or (if they have been separated for all of the last 6 months of the tax year and have paid more than half the cost of maintaining a household for a qualified child), they can use a more favorable status establishing them as the head-of-household. Both separated parents have the opportunity to use this status if they are paying more than half the cost: otherwise, the spouse who is not providing that level of support is required to file married but separate while the parent providing economic support can use the head of household status. Once all the papers have been signed and the couple is officially divorced, each ex-spouse can file either single or (if they qualify) as head of household.
  • Tuition Credit - There are two tax credits available for higher education — the American Opportunity Tax Credit and the Lifetime Learning Credit. When a child qualifies for either of these credits, the parent who claims them as a dependent is the parent who takes the credit. This is true regardless of who is paying tuition or qualifying expenses.

Births and Deaths

Birth and Adoption

Most people who are expecting a child put together a long to-do list of items they need to purchase and tasks they need to accomplish. Along with attending birthing classes and purchasing baby clothes, parents need to make sure that they alert the IRS when their child is born, as along with the joys and travails that accompany a newborn there is also a maximum $2,000 child tax credit meant to offset the monumental financial impact of raising a child. For those who itemize, 10% of the medical expenses involved with the child’s birth are deductible if they exceed adjusted gross income. Parents who choose surrogacy are not permitted to include the surrogacy medical expenses in their deductible medical expenses.

There is also a credit available for childcare expenses, which for married couples where both spouses work can result in a maximum credit of between $600 and $1,050 for a single child. (That amount doubles for more than one child.) The childcare credit is based on a $3,000 per child maximum allowable expense that is multiplied by 20 to 35 percent, depending upon the parents’ income level. Again, for two or more children the maximum expense and credit doubles.

Birth is not the only way you can add a child to your family. Those who adopt a minor child or an adult individual who is physically or mentally unable to care for themselves are also able to take tax credits. There is a qualified adoption expense deduction with a maximum of $14,080 for 2019, and though it is not refundable it can be carried over for up to five years. This credit does phase out for high income earners, and if an adoption involves a special needs child the credit limit is to be taken the tax year when the adoption becomes final, regardless of whether qualified adoption expenses were paid in a year previous to that.

Tax-free growth can be realized each year for contributions to specific types of educational savings accounts, and parents who plan on putting money aside are advised to take advantage as early as possible to optimize the benefits. The two types of accounts are the Coverdell, which allows a maximum contribution of $2,000 per year, and Sec. 529 plans (also known as Qualified State Tuition plans), which allow unlimited deposits. Though neither type of contribution is tax deductible, having the ability to grow the funds on a tax-free basis is a big plus.

Death of a Spouse

Just as filing status and other taxation elements are affected by a marriage or divorce, when a spouse loses their partner there are a number of issues that will need to be addressed sooner rather than later.

  • Notification to Social Security for those who had been receiving benefits. Surviving spouses not only need to tell the Social Security Administration that their spouse has died, but also need to make any pensions or retirement plans aware of their passing.
  • Title Changes ­– Any jointly held assets will need to be transitioned into the surviving spouse’s name alone (or into any other joint ownership that they prefer).
  • Filing Status - A widow or widower can file a joint return for the year that their spouse has died as long as they have not remarried during that year. The married status will no longer be applicable for the following year, and the surviving spouse will need to file as either single or head of household.
  • Estate Tax – Payment of estate tax may be required if the deceased spouse’s assets and prior reportable gifts are more than the current lifetime inheritance exclusion. For 2019 that amount is $11.4 million, though that number changes frequently based on congressional action. In some cases, an estate tax may not need to be paid as a result of the deceased’s estate falling below the exclusion threshold, but it may still be wise to file the estate tax return anyway in preparation for the eventual impact of the surviving spouse’s death.
  • Inherited Basis – The tax basis of assets inherited by a beneficiary are generally considered to be equal to their fair market value on the day of the benefactor’s passing. This means that the assets should be appraised as quickly as possible. Unfortunately, this process is not as clear cut as it sounds, as questions of how an asset is titled and the property and inheritance laws of each state need to be taken into account.
  • Trust Income Tax Returns – Couples who engage in estate planning frequently create living trusts for themselves, together. These are revocable, and as long as both are alive there is no need to file a separate tax return. But when one spouse dies the trust is sometimes split into two, and that means that a separate tax return will need to be prepared and filed each year for the deceased spouse’s trust, which will have automatically become irrevocable.

Purchasing a Home

The most commonly-cited cliché about purchasing a home is that it is the single biggest investment you’ll ever make, whether you’re buying as a millennial or a baby boomer. It also represents an enormous amount of responsibility and a shift in many aspects of your tax liability. Not only will you be responsible for paying property taxes, but you will also have to purchase insurance and pay a mortgage. The good news is that both the interest on the money you’ve borrowed and the property taxes you pay are tax deductible, and will substantially reduce the amount you owe the government unless the standard deduction for your filing status is more than all of your combined deductions.

This is something you should consider before signing on the dotted line: if you’re thinking that buying a home will give you a tax break, do the math first to make sure that will really happen.

The other tax-related aspect of home ownership comes at the time of sale. If your home appreciates in the time that you own it, the government allows you to exclude up to $250,000 (or $500,000 for a married couple) in gains from your income. The only requirement is that you have owned and used it as your primary residence for two out of the five years leading up to the sale.

The examples provided here are just the highlights of the many ways that big life events can impact your tax status and liability. If you are anticipating a change, it’s probably a good idea to make an appointment with your tax professional to learn more.

Gordon W. McNamee, CPA writes for TaxBuzz, a tax news and advice website. Reach him and his team at [email protected].

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Gordon W. McNamee

Gordon W. McNamee

Gordon W. McNamee is a Certified Public Accountant (CPA) based in Rancho Cucamonga, CA. Gordon W. McNamee can assist you with your tax return preparation, payroll, accounting and tax planning needs. <br /> <br /> 2021 is Gordon W. McNamee, CPAs 38th year in the profession. As as a former IRS agent (1984 through 1987), Gordon has been in public accounting since 1987. Gordon specializes in individual, corporate, HOA, trust, estate and payroll taxes. He also prepares financial statements and provides accounting & bookkeeping services. He enjoys making his clients feel at ease while providing a personalized professional service.

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