The U.S. Supreme Court’s decision in United States v. Windsor strikes down a key provision of the 1996 Defense of Marriage Act (DOMA) and means that many same-sex married couples will be treated as married for federal tax purposes.
Tax treatment as a married couple can provide numerous tax-saving opportunities, but in some cases it can result in negative tax consequences.
Background
Windsor concerned the constitutionality of Section 3 of DOMA, which defined marriage for federal benefits purposes as being between a man and a woman, thus denying federal benefits — including being treated as a married couple for federal tax purposes — to same-sex married couples. The Court struck down Sec. 3 as a violation of the U.S. Constitution’s guarantee of equal protection under the law.
But the Court didn’t go so far as to find that same-sex couples have a fundamental right to marry. The decision simply said that, if a same-sex couple’s marriage is legally recognized in their state, the federal government must recognize it as well.
So, the 30+ states that don’t recognize same-sex marriage won’t be required to begin doing so. And if a same-sex married couple was legally wed in a state allowing such unions but resides in — or subsequently moves to — a state that doesn’t recognize them, the Court’s ruling doesn’t require the federal government to recognize the marriage. Nevertheless, IRS guidance and other federal regulations could expand eligibility for federal treatment as a married couple to these couples.
In addition, another Supreme Court decision issued June 26, Hollingsworth v. Perry, effectively increased the number of states recognizing same-sex marriage by not reversing a lower court’s decision to strike down the ban against same-sex marriage in California, the country’s most highly populated state.
Tax advantages of marriage
The Internal Revenue Code provides several tax advantages to federally recognized married couples, such as the following:
Marriage bonus. In some cases, jointly filing a federal income tax return can result in a lower combined tax bill than if the couple were unmarried. This typically occurs when one spouse earns most or all of the income.
For instance, suppose Barry and Mike are married, and Barry earns all of the income. In 2012, Barry’s tax liability as a single filer was approximately $61,000. Mike didn’t even need to file a federal tax return. Recalculating their tax liability as a married couple filing a joint return yields a joint tax liability of less than $48,000, for a tax savings of more than $12,000. This is because, with a joint return, more of the higher-earning individual’s income is taxed at lower rates.
Same-sex married couples who could benefit from the marriage bonus may be able to file amended returns for previous tax years and receive a refund.
Another potential “marriage bonus” is that a non-income-earning spouse could be eligible to contribute to an IRA, whether traditional or Roth. A tax-deductible contribution to a traditional IRA would, of course, further reduce the couple’s income tax liability.
Tax-free employer benefits. Federal tax law allows one spouse to receive certain tax-free benefits from the other spouse’s employer. The most common examples are tax-free health care coverage and tax-free reimbursements from health care Flexible Spending Accounts (FSAs).
Same-sex married couples should look into whether they, as a federally recognized married couple, are now eligible for any new employer benefits. They also might be able to file amended returns and receive a refund for previous years when taxes were paid on benefits.
Deferral of distributions from inherited retirement accounts. When one spouse dies, the surviving spouse can roll over qualified retirement plan balances — such as from 401(k) plans — inherited from the deceased spouse into his or her own IRA. Then, the surviving spouse can put off taking annual required minimum distributions (RMDs) from the rollover IRA until after he or she reaches age 70 1/2.
In contrast, when a nonspouse inherits a qualified retirement plan balance and transfers it to a rollover IRA, he or she will usually have to start taking RMDs sooner and in larger amounts. This means that the nonspouse loses the benefit of tax deferral, and may also be subject to more income tax as a result of having to take the distribution.
Similar tax treatment applies to IRAs. When one spouse dies, the surviving spouse can also roll over IRA balances inherited from the deceased individual into his or her own IRA. Once again, the RMD rules that apply in this situation allow surviving spouses to defer distributions longer than nonspouses who inherit.
Same-sex married couples who may be eligible should review their retirement plan beneficiaries and planning strategies related to these accounts and determine if any changes should be made.
While there is still much uncertainty, anyone who had previously inherited a retirement plan from a same-sex spouse should review whether that IRA might qualify for deferral as a spousal rollover going forward.
Gift and estate tax breaks. U.S. citizen spouses can make unlimited transfers to each other during life or at death free of federal gift and estate tax under the marital deduction.
In addition, when one spouse dies, his or her estate can elect to allow the surviving spouse to use any unused estate tax exemption ($5.25 million for 2013, reduced by any taxable gifts made during life). The surviving spouse can use the exemption to shelter more gifts from the federal gift tax and have more estate tax exemption available when he or she dies.
Same-sex married couples with larger estates may benefit from reviewing and revising their estate plans in light of the new tax breaks that may be available to them. They also may be able to obtain refunds for taxes previously paid.
Deductibility of alimony payments. Divorce can also provide tax benefits in some cases. Certain court-ordered payments to an ex-spouse can qualify as deductible alimony. In contrast, transfers of money between unmarried individuals generally aren’t deductible and may be treated as gifts for federal tax purposes.
It should be noted that there are statutes of limitations for filing amended returns. The number of years you can amend varies for the tax advantages listed above.
Marriage penalty
One big disadvantage of being considered married for federal tax purposes occurs when both spouses have healthy amounts of taxable income. In this scenario, a married couple can owe a larger combined federal income tax bill than if the two individuals were single taxpayers.
As a result, same-sex couples now considered married for federal tax purposes could find themselves facing larger tax bills. In these situations, smart tax planning is critical.
Uncertainty remains
For same-sex married couples — and same-sex couples considering marriage — the Supreme Court’s decision has substantial tax implications. At least for the time being, a same-sex married couple’s state of residence generally will determine whether they can enjoy the federal tax benefits of marriage. The rules with respect to residency, however, are different for certain nontax benefits, further complicating the post-DOMA financial landscape.
So same-sex married couples in every state should work closely with their tax and estate planning advisors to monitor developments and determine when changes to their income tax strategies and estate plans may be warranted — and to be aware of the nontax benefits available. Same-sex couples with civil unions and domestic partnership agreements should also keep an eye on developments.
If you have questions about how the Supreme Court’s DOMA decision may affect your situation, please contact us.
