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How Marriage Equality Affects your Retirement: IRA Tax Loopholes Available to Opposite-Sex Married Couples Only

Individual Retirement Accounts (IRAs) are powerful tools for funding your future. Putting money into an IRA can be a great way to save for your retirement because it provides tax benefits in the present. Unlike some retirement plans, IRAs can be set up by anyone; they do not have to be set up by your employer.

One of the major benefits of an IRA is that all or a portion of your contributions may be tax deductible and some taxpayers can claim a tax credit for their contributions. Additionally, any earnings on the money you’ve put in will be tax-deferred until you take the money out. This benefit is particularly useful if you expect your annual income to be less during retirement years.

There are, of course, eligibility requirements for participating in an IRA. First, you must be under age 70 ½, and second, you may only contribute if you have taxable compensation for the year. Each year the IRS assigns a maximum dollar amount that can be contributed; it is currently $5,000. Anyone under age 70 ½ can contribute the lesser of that $5,000 or their taxable compensation. As an example, if you earn $6,000 you can only contribute $5,000; if you earn $3,500 you can only contribute $3,500.

It is this “taxable compensation” rule where we come to our first loophole only available to straight married couples, i.e. “spouses” as defined by DOMA. If you are otherwise eligible to contribute to an IRA but are not working, and therefore have no taxable compensation, you can use your spouse’s income to qualify you for contributions. When one spouse earns $10,000 and the other earns $0, both can contribute up to $5,000. Unless of course the non-working spouse is part of a same-sex couple, in which case no contribution is allowed.

This means that if a person has enough cash to contribute the maximum every year, but isn’t allowed to because they have no taxable compensation and aren’t considered a spouse, they miss out on up to $5,000 in tax deductions every year. This essentially results in a gay person having to pay a potential $500 to $1,400 more in taxes, per year, than their straight counterpart.

Next let’s talk about what happens when you pull the money out of these plans. Depending on what portions of your contributions were deductible, the distributions may be fully or partially taxable as ordinary income. Furthermore, if you pull the money out before you’ve reached age 59 ½ a 10% penalty will be imposed. Luckily, for some, there are a few ways to get out of paying this.

The IRS has provided several exceptions that allow a taxpayer to avoid the 10% penalty. While under the right conditions most of them are available to all taxpayers, there are also circumstances in which they are not. There are three exceptions that apply to individuals who take a distribution to pay for certain expenses for themselves or their spouse[i].

The money can be pulled to pay for health insurance premiums for an unemployed taxpayer or their spouse.
The money can be pulled to pay for higher education expenses for the taxpayer or their spouse.
The money can be pulled to pay for the purchase of a home if the taxpayer or their spouse qualifies as a first-time home buyer.

As an example of these rules in practice, let’s imagine a $10,000 distribution used to pay for higher education expenses. One man can pull out $10,000 to pay for his wife’s education without penalty while another man who pulls out $10,000 for his husband’s education has to pay a $1,000 penalty.

Don’t get me wrong; the rules were created with good intention. They are theoretically providing financial incentive for people to stay insured, go to college, and purchase homes. The problem, albeit unintended, is that in this context, the exclusion of same-sex partners from the federal definition of spouse makes health insurance, education, and homes less accessible to the LGBT community.

Until rights and laws are applied equitably, we must work to understand the consequences of our legal inequality. The benefits of marriage are more expansive than many of us realize. I fear that as same-sex marriage begins to feel more attainable, those fighting for it will lose their sense of urgency. Unfortunately, when it comes to financial rights and obligations, the inequality of today can have a tremendous impact on the future. Gaining parity ten years from now will not make up for present imbalance.

[i] In many cases the funds can also be pulled for children, grandchildren and certain other family members.

Loss of Head of Household Status for Registered Domestic Partners in Washington and Nevada and Same-Sex Married Couples in California

As taxpayers we are always looking for ways to keep more of our money. If you are unmarried, one of the easiest ways to save on taxes is to file as Head of Household (HOH) instead of Single. The HOH filing status has both lower tax rates and a larger standard deduction. Together, these advantages can have a significant impact on your tax bill.

RDP taxpayers have been claiming HOH status under varying circumstances for many years. Some have a child living in the home while others have been claiming their non-working spouse as a dependent in order to meet HOH requirements. In some cases, though technically incorrect, RDPs have even both filed as HOH when the couple has more than one child.

There are certain requirements, commonly referred to as “tests,” that must be met in order to claim HOH status. Unfortunately, the community property income splitting rules have caused most RDPs to suddenly fail to satisfy the requirements.

There are three tests and they must all be met to qualify for HOH status:

Taxpayer must be unmarried, or “considered to be unmarried.”
Taxpayer must pay for more than half the cost of keeping up the home.
Taxpayer must have had a “qualifying person” (usually a child) living in the home more than half of the year[i].

The first test remains easy to meet since under all circumstances RDPs are still legally single for tax purposes. If you have a dependent child, the third test also remains easy to meet. In most cases however, if you don’t have a child you will no longer be able to use your dependent partner to satisfy the third test. There are additional tests to meet in order to claim a dependent partner as a qualifying person. For purposes of this discussion, only one of these tests is relevant. The partner must have gross income of less than $3,700; this is known as the “gross income test.”

Now that wages, and most other types of income, are reported 50/50 between the partner’s two returns, it is almost certain that both partner’s incomes will exceed $3,700[ii]. With no child or partner who can be considered a qualifying person the third HOH test is not met and the taxpayer must file as Single.

The more common, yet less complex, reason for losing HOH status is failing to meet the second “cost of keeping up the home” test. Since, typically, under community property rules all income is split 50/50, neither partner can qualify as paying for more than half of the cost of keeping up the home. HOH status is lost and both partners must file as Single.

Luckily with some strategic planning, assuming the first two tests are met, there are ways to ensure that one partner can still file as HOH. All that is needed is any amount of separate income. If one partner has separate income, then their share of total income will be greater than 50% and may then justify the claim that they provide more than 50% of the cost of keeping up the home.

What is separate income then? There are several income sources that are intrinsically considered to be separate:

Income from an inheritance provided that the underlying assets earning the income have remained physically separate and have not commingled with community property assets.
Distributions from retirement funds that were earned, partially or wholly, prior to registration or marriage.
Distributions from IRA accounts are always considered separate regardless of whether they were funded by property otherwise considered as community.
Social Security benefits that were earned, partially or wholly, prior to registration or marriage.

There are a number of other grey area income sources, such as Health Savings Account distributions, to which the IRS has made no comment. Income may also be designated as separate by creation of a separate property agreement. Regardless of the source of the separate income, having it or creating it can be a financially rewarding planning strategy. You may want to consult your tax professional to determine how, and if, you can maintain your eligibility to file as HOH.

[i] There is an exception to this rule. If you have a parent that you can claim as a dependent, they do not have to live with you.

[ii] This creation of reportable income also usually means that the non-working spouse must now file their own tax return when they didn’t before.

Will the Supreme Court Kill DOMA in 2013?

Court cases challenging DOMA are popping up across the nation with increasing frequency. Over the last two years, the legislative momentum has grown dramatically. We are now at a point where we can expect at least one of these cases to be heard by the Supreme Court. The implications of the Supreme Court hearing such a case are enormous. We could be within a year of undefining, as opposed to redefining, marriage. If we are successful in broadening the federal definition of spouse to include partners of the same sex, many currently unavailable federal benefits will become accessible to our partners.

There are two key cases currently making their way through the courts.

Perry v. Brown (California)

This is the infamous Prop 8 case formerly known as Perry v Schwarzenegger. In February of 2012 a three judge panel, in a monumental decision, held that prop 8, which amended the state constitution to disallow same-sex couples from becoming married, was unconstitutional. The judges found that there was no “rational basis” to restrict same-sex couples from the right to marry. Judge Reinhardt, who authored the opinion, declared that Prop 8 violated the Equal Protection Clause stating:

“Proposition 8 singles out same-sex couples for unequal treatment by taking away from them alone the right to marry… the People of California may not, consistent with the Federal Constitution, add to their state constitution a provision that has no more practical effect than to strip gays and lesbians of their right to use the official designation that the State and society give to committed relationships, thereby adversely affecting the status and dignity of a disfavored class.”

Golinski v Office of Personnel Management (California)

This case stems from a from a 19-year old woman’s complaint after her application to include her wife under her employer-provided health coverage was denied. While this case may not be as well-known as the Prop 8 case, it is widely considered to be the one with most potential for success. In July, the Department of Justice filed a writ of certiorari, basically a request that the Supreme Court hear the case. Many expect the Supreme Court will accept despite the fact that these requests are rarely granted. This is especially noteworthy since the request asks that the Supreme Court hear the case before it makes its way through the remaining lower court appeals. This unusual writ also includes a request to combine the case with two others challenging DOMA’s constitutionality.

Between the two cases, there is widespread conjecture that Golinski not only has a better chance of being heard by the Supreme Court but also has a better chance of being upheld. At a conference I recently attended[i], Oregon attorney Cynthia L Barrett speculated that a win in the Brown case could require that the court issue a blanket decision allowing same-sex marriage in all 50 states. The Golinski case may instead only require a decision allowing federal benefits on a state by state basis. The expectation is that the benefits would only be available to those holding a valid sate marriage certificate in one of the six states[ii] that allow gay marriage.

Considering the pace with which states are attempting to pass same-sex marriage legislation, perhaps a Supreme Court decision of this magnitude will serve to further that drive. In the current environment, where it is no longer possible to stand against same-sex marriage without significant backlash, as evidenced by the recent Chik-Fil-A controversy, we can, finally, imagine an attainable and expedient move towards federal marriage equality.

[i] Barrett, C.L. Ask. Tell. LGBT Estate Planning Developments, Multnomah Athletic Center, Portland, Oregon; OHSU Foundation: June 2012

[ii] Gay marriage is also legal in Washington DC and is pending in the State of Washington.

The Adoption Tax Credit – One Good Thing the Defense of Marriage Act did for Registered Domestic Partners

Despite the adverse effect that the Defense of Marriage Act has on millions of LGBT people, there is one instance in which it helps. That instance is the availability of the Adoption Tax Credit to those who adopt their partner’s children. This of course only applies to those living in states that allow second-parent adoptions; but still, this one bit of law provides a benefit that would be otherwise unavailable if same-sex marriage was federally recognized. Let me explain.

The Adoption Credit is intended to provide financial relief and assistance to those who adopt children who do not already have a parent. For this reason, there is an exception rule that says that a taxpayer does not qualify for the credit if they are adopting the child of their spouse. There’s that word again, only this time, it’s a good thing. Because the word “spouse” is used, RDPs are eligible for the credit when adopting a partner’s child. After all, we’ve been told time and again that partner’s are not spouses. Period. For once, the rigid federal definition of marriage provides a benefit to LGBT people instead of harming them.

The Adoption Credit has been around for some time, at least as far back as 1996 when Bill Clinton signed the Small Business Job Protection Act. The credit was then created specifically to benefit those adopting special needs children. Over the years, the character of the credit has changed as various provisions have been passed and have expired. Perhaps the biggest moment in the history of the Adoption Credit was in 2010 when President Obama signed the landmark Affordable Care Act. In addition to increasing the amount of the credit to roughly $13,000 per child, up from Clinton’s $5,000, the act also made the credit refundable.

Tax credits are either refundable or non-refundable and most are non-refundable. The distinction is significant. A non-refundable credit will reduce any tax owed to zero, but not below. A refundable credit is one that will reduce your tax to zero and then refund you any excess. So, if you have a $1,000 non-refundable credit and $800 tax owed, you end up with zero tax and zero refund. If you have a $1,000 refundable credit and $800 tax owed, you will receive a $200 refund.

Sadly, the refundable character of the credit is set to expire for the 2012 tax year. As it stands now, if there are no changes, the credit will still be available for all 2012 adoptions but will be non-refundable. In 2013 it may be non-refundable and only apply to special needs adoptions. Although these attributes of the credit are scheduled to expire, President Obama has already once attempted to make changes. Unfortunately, the attempt failed as it was wrapped up in his ardently defeated budget proposal. The changes would have made the credit refundable for 2012/2013 and permanently available as non-refundable for all adoptions thereafter.

What happens with the Adoption Credit for the 2012 tax year remains to be seen. I expect tax law changes through early 2013, as is typical. Still, if you are planning to adopt your partner’s child, 2012 may be the year to consider it.

Social Security Issues for Registered Domestic Partners in Washington State

The absence of federal marriage equality has a powerful impact on your social security. I briefly touched on this in a previous post, Washington to Legalize Same-Sex Marriage?. What I discussed there was in the context of survivor benefits which is unfortunately only one of the social security issues that “unmarried” couples face.

Let’s start with how you accumulate the benefits in the first place. When you are an employee, your employer withholds social security taxes from your wages at the rate of 6.2%. Additionally, your employer makes a match of this withholding at their own expense. The amounts are reflected on your W2 and from here go toward your social security credits; in other words, this is where your social security benefits come from. These amounts, from wages, are not affected by the income-splitting rules for RDP taxpayers. Even though you will be combining and splitting your W2 wages for income tax purposes, the social security credits are still calculated from your employment records.

This is not the same for self-employed people. When you are self-employed, you report and pay your own social security tax, and since you employ yourself, you also have to pay the match. This means you are paying taxes on your earnings at 12.4% instead of 6.2%, a part of what is collectively known as self-employment tax. The tax is calculated on your return as a percentage of your net self-employment income (net profit). On a married filing joint return, self-employment income is linked to a social security number so that only the earner is credited for the social security. When spouses file separately in community property states, even though the self-employment income is split, the self-employment tax is only imposed upon the earner or owner of the business.

The same is not true for RDPs. The special rule allowing the self-employment income earner to receive full credit for the social security, so as to be comparable to how it works with wages, only applies to spouses. Again, because of semantics, these protections do not extend to RDPs. Many tax preparers, including me, feel that the IRS’s position on this issue is incorrect.

There are consequences to this treatment of self-employment tax. Firstly, if both partners are working, it means that one partner is getting 100% credit for the social security attributable to their own wages and 50% of the social security attributable to their partner’s self-employment income. The self-employed partner is only getting 50% of their self-employment credits and 0% of their partner’s wage credits. For many, this is a problem, but for some it could be a benefit.

If one partner is self-employed and the other is not working at all, this treatment allows the non-working partner to accumulate social security credits. This can be extremely important for some since, unlike spouses, a surviving partner is not eligible to receive the deceased partner’s unused benefits. It basically provides a loophole to funnel social security benefits to a non-working partner.

To me though, this potential benefit does not outweigh the potential drawbacks. As is the case with many problems arising from unequal federal rights, there is an issue of double taxation. Let me explain. There is a wage base for social security tax. This means that once you exceed a certain wage level, the earnings above that level are no longer subject to social security tax. In 2012, that base is $110,100 and it applies to both wages and self-employment income. So, if a single or married person makes $150,000, only the first $110,100 is subject to the social security tax. What if you are an RDP in a community property state with $150,000 in self-employment income? The full $150,000 is taxable.

An example: One partner has $200,000 in self-employment income. The rules require this to be split so that each partner reports, and is taxed on, $100,000. Both partner’s shares are now, in their entirety, subject to social security tax since the reportable amounts are both beneath the wage base. This means that social security tax is imposed on the whole $200,000 resulting in $11,148 more tax than a married or single person would have to pay.

While it’s true that most RDP taxpayers are not bringing home over $110,100 in self-employment income, I find it extremely alarming that this sort of disparity in taxation is built into our current tax system. Of course, there are ways to get around this taxation issue. However, to do so would require consulting a financial or legal professional; just another example of the unnecessary burden the income splitting rules put on RDP taxpayers.

Washington to Legalize Same-Sex Marriage?

The State of Washington may be on its way to becoming the seventh state, in addition to Washington D.C, to legalize same-sex marriage. In 2007 Washington legalized domestic partnerships, then, in 2009 it expanded the rights of registered domestic partners to include “everything but marriage” as the passing bill became known. Now, in 2012, Governor Christine Gregoire has announced her support for legal same-sex marriage in Washington State.

Shortly after Gregoire’s announcement, House Bill 2516 and Senate Bill 6239 were introduced by Representative Jamie Pederson and Senator Ed Murray respectively. The legislation would allow for same-sex couples to apply for and receive marriage licenses in Washington. Also in the bills is an amendment providing religious officials an exemption from performing services for such marriages. Interestingly, this amendment changes the language from: “minister or priest of any religious denomination” to “minister or a priest, imam, rabbi, or similar official of any church or religious organization.” Perhaps my favorite part of the bill though is an added section that includes the term “gender neutral:”

Where necessary to implement the rights and responsibilities of spouses under the law, gender specific terms such as husband and wife used in any statute, rule or other law must be construed to be gender neutral and applicable to spouses of the same sex.”

Since January 23^rd, when Senator Mary Margaret Haugen, the deciding vote, announced her support, the bills have been expected to pass both the House and the Senate. Upon passage, opponents will begin soliciting signatures in an attempt to get a challenging referendum on the ballot for public vote. To do so, they need only collect 120,577 signatures by July 6^th.

This is reminiscent of what took place in 2009 when the “everything but marriage” bill was passed. Opponents collected the required number of signatures and placed Referendum 71 on the ballot. I recall my time working as co-coordinator of the Olympia chapter Approve Referendum 71 campaign and fear that some of the same confusion will occur. Because of the wording of the referendum, the beginning of the campaign was dedicated almost entirely to explaining that voting in support of the referendum actually meant voting in support of the original “everything but marriage” bill. The number of voters unaware that voting against the referendum, brought by opponents, was in fact siding with them was astonishing.

Last night, just as I sat down to write about this, I received a phone call from an Equal Rights Washington phone bank volunteer. His script began by notifying me that I had donated during the Referendum 71 campaign and that they were now looking for support for ERW’s campaign for marriage equality. I soon found myself in a long and emotional conversation as I jabbered on about how I was, at the very moment, writing a blog about the bills and, also, about the tax work I now do with registered domestic partners. He told me of his partner of 14 years who passed 22 months ago. He explained that he did not understand, until his partner’s death, the breadth of the impact of not having the very rights he was fighting for.

His partner was a dedicated worker who refused to begin drawing social security and preferred instead to continue working. By the time he passed he had accumulated significant social security benefits. Because their relationship is not federally recognized, the surviving partner is ineligible for the same social security survivor benefits afforded spouses. As a result of losing half of his household income, and not being eligible for the same federal benefits married couples receive, this ERW volunteer will likely lose his home. It is these nuances of the law that have a tangible and often life-changing impact on the lives of people that do not have the right to marry. Unfortunately, legalization of same-sex marriage in Washington State will have no immediate effect on such federal rights. We can only hope that with each state that passes similar legislation we will be one step closer to federal marriage equality.

If you do plan to marry in the State of Washington, there are some things to consider. For those who are already in a registered domestic partnership, your registration will not immediately and automatically turn into a marriage. Registered domestic partners will need to apply for a separate marriage license. Once married, the partnership will be automatically dissolved. This will remain true until June 30^th 2014 at which time, if you are in a registered domestic partnership and have not yet applied for a marriage license, your partnership will automatically be deemed a marriage. For legal purposes, the date of marriage will become the date of your domestic partnership registration.

It’s Tax Time: What You Need to Know if You are a Registered Domestic Partner in Washington State

In 2010, the IRS made drastic changes to the filing requirements for Registered Domestic Partners (RDPs) in Washington State. Didn’t know about these changes? You are not alone. It was a scramble for many in 2011. Some learned of the changes just before the filing deadline, while others remained unaware until after they had filed their returns.

During the 2010 tax year, the IRS began to acknowledge the community property rights granted to Washington RDPs under state law. At first, a federal agency recognizing same-sex relationships sounded exciting. It soon became clear however that the IRS is certainly not recognizing these relationships. Rather, they are simply allocating and taxing income according to who Washington says it belongs to. This is not to say that the new rules are a bad thing. While they still fail to provide the same tax protections afforded spouses, the new rules are beneficial to many RDP taxpayers. The trouble is that they are confusing and burdensome to follow.

For spouses, who are able to file jointly, community property does not pose a problem. Everything is combined onto one return so it doesn’t matter whose is whose. For RDPs, who cannot file jointly, recognition of community property is a big problem. In a community property state, the old adage “what’s mine is yours, what’s yours is mine” is true, and it applies to income. The question then becomes how to report this income for tax purposes.

Let’s start from the beginning. This is not the first time that taxpayers have been faced with this problem. The community property concept dates back to early Germanic tribes, long before the advent of joint tax returns. Community tax reporting issues first arose in the 1930s when a man by the name of Seaborn, coincidentally from Washington, reported only half of his wages to the IRS. Seaborn reasoned, and rightly so, that he should only have to pay tax on half of the income since, according to state law, only half of it was his. The IRS disagreed and assessed interest and penalties on his return. A series of legal battles then began and the US Supreme Court eventually ruled in Seaborn’s favor. As a result, Congress amended the tax code and created joint tax returns.

Once spouses were able to combine income onto one return, the issue was largely forgotten. Then, seventy five years later, California became the first state to grant community property rights to same-sex couples and a similar tax reporting problem arose. The first arguments for RDP community property recognition began in 2005. When the IRS responded, one year later in 2006, they said that the precedence created by the Seaborn case only applied to spouses and that RDPs are not spouses as defined by the Defense of Marriage Act (DOMA). After several court cases in the state of California, culminating in May of 2010, the IRS finally changed its position. Now, same-sex spouses in California, and by default RDPs in Washington and Nevada, are required to file according to community property rules.

Unfortunately, there is very little IRS instruction on how to follow these rules. To date, the only guidance is an FAQ page and a publication that was originally written for spouses who are married filing separately. The IRS merely inserted “Or RDP/Same Sex Spouse in California” throughout the text of the publication and, thanks to DOMA, much of it is inapplicable as it is filled with explanations of rules that only apply to spouses.

Luckily, once you figure out how to file the return, and what numbers to put on it, the end result may be a larger refund. Those who benefit most are couples in which one partner is a significantly higher earner than the other, or those in which one partner does not work at all. In these situations, when the incomes are combined and split, because most income is community income, the income is taxed at a lower rate. For example, if one partner makes $100,000 and the other $0, and it is all community income, each partner will report $50,000. The tax rate is lower at $50,000 than it is at $100,000. This means that the entire $100,000 is taxed at a lower rate, resulting in less tax owed. In the example above, even a 2% drop in tax rate could mean a $2,000 savings.

Additionally, the IRS is allowing, but not requiring, taxpayers to amend prior year returns in order to apply the rules retroactively. You may want to consider amending your 2009 and 2010 returns. If the new rules would have resulted in a larger refund in one of these years, amending may get you a check from the IRS, with interest.

The new rules can be complex and there are many issues I have neglected to go into here. I’ll be posting more entries discussing these issues in more detail, along with various methods of handling them. Until then, take solace in the confusion. Many believe that these uncertainties will lead to a new federal filing status option for Registered Domestic Partners. As unsatisfying and incomplete as the new rules are, they just may be a stepping stone to marriage equality.