Tip of the Month:
New Tax Law Impact on Timing of Divorce

In November, 2002, the monthly tax tip was "When both parties work and neither party is very low paid, get the divorce in the current year and these individuals will reduce their taxes". The new tax law has changed that advice and now the tax tip for the timing of divorce from a tax perspective is: "When both people work and neither is very high paid, the timing of the divorce will not materially change the combined taxes of the individuals".

The new tax law has eliminated the "Marriage Tax Penalty" when income is under $65,000 per year.

Background
When the federal income tax rates were increased in 1993, the top rate of 39.6% was set to apply in each filing status at the same level of income. For 2003, the top rate has been reduced to 35% but that one rate applies at taxable income of $311,950 or more regardless of whether the filing status is Single, Head of Household, or Married, Joint.

The impact of this is that working couples who file as Married, Joint can pay significantly more federal tax than if the same two individuals earning the same income were not married. This is referred to as the "Marriage Tax Penalty."

This was a significant change from past tax rate schedules in which the "Marriage Tax Penalty" did not exceed about $2,200. In 2003, after the tax law changes, the "Marriage Tax Penalty" can still be as high as $12,500. (Two married professionals each with Adjusted Gross Incomes of $317,000 will pay an additional tax of $12,542 just because they are married.) The new tax legislation of 2003 has generally eliminated the Marriage Tax Penalty for individuals with income under $65,000 but the penalty still applies at higher income levels.

New Tax Law – May, 2003
The new tax law has eliminated the "Marriage Tax Penalty" at lower income levels by:

• Increasing the standard deduction for Married Joint to twice the standard deduction for Single
  (Single is $4,750 and Married, Joint is now $9,500 vs $7,950 before the tax law changes)
  
• Making the standard deduction for Married Separate the same as Single ($4,750)
  
• Making the Married, Separate tax brackets for 10% and 15% rates the same as Single
  
• Making the maximum income level for the 15% tax bracket for Married, Joint to be twice the amount for Single. The new 15% brackets are:
  

Implications for Divorce – Case with No Children
What this means is that if both parties to the divorce are working and neither party is high paid, these couples may save taxes if they stay married and file a joint return. This is completely different from what they should have done in the past when it would make tax sense to get divorced in the current year to avoid the “Marriage Tax Penalty”. Family lawyers will need to look at the numbers for individual situations but in general the "Marriage Tax Penalty” has been eliminated or lowered.

In addition, the new tax law makes the tax for a Single filer the same as for a Married, Separate filer at incomes of up to $65,000 per year. This is important in divorce because separate pre-divorce tax returns eliminate potential problems of a fraudulent joint return. Separate returns eliminate the need to use the “Innocent Spouse” rules if there is a fraudulent return.

The following table shows the impact of the “Marriage Tax Penalty” at different income levels for individuals without children:

The following situations result in less tax if a Married, Joint return is used assuming one higher paid and one lower paid party. However, these situations may involve temporary support (alimony/maintenance) which will swing the analysis to getting divorced in the current year instead of the results shown below.

When income is different but neither party is very low paid, tax differences are not significant and very different from before the tax law changes when getting divorced and filing as Single made tax sense. From a tax perspective, the timing of divorce is now more neutral than in the past.

If the divorce is to take place late in the year, the tax impact of divorcing in the current or next year should be assessed. In the situation where there are no children, the general rule will be that taxes will not be saved by getting divorced in the current year in most cases except when both individuals make more than $65,000. The tax savings from filing as Married, Joint are not extremely significant in most situations. The divorcing couple can decide on the timing of the divorce without being overly concerned about the taxes being paid in the year of the divorce assuming the divorce is taking place late in the year and the parties are not both high paid.

When there are children, the analysis is more complicated since credits can be involved and these credits may be more widely available to a Head of Household filer than to a married couple (Earned Income Credit). In general, joint taxes may be reduced by filing separate pre-divorce tax returns compared to a married, joint return when both individuals work and they have lived in separate households for more than ½ the year so one person can file as Head of Household with the other filing as Married, Separate. Significant tax savings may be available if the Head of Household filer is lower paid and can make use of the Earned Income Credit (under $33,700 of income with 2 children).

The timing of divorce when there are children will be the subject of a future tax tip.