According to an article by the WSJ, Eric Rey of Berkeley, CA asked the IRS for clarification on how he and his same-sex domestic partner should report their income for tax purposes.  California is a community property state, and domestic partners must each report half of their combined income.  Until now, income could only be split by the 5% of California’s domestic partnerships that are heterosexual.  Since My. Rey earns much more than his partner, it would significantly lower their overall tax burden, if he could shift half of his income to his partner.  This week, the IRS ruled that all domestic partnerships in Calfornia must report half of their combined income on each partner’s individual tax return.  

The IRS is considering whether the new ruling will apply to other community-property states.

The WSJ article is titled: “Gay Couples Get Equal Tax Treatment,” but in truth it is a favorable treatment.  Splitting income is even better than filing as a married couple, which has the potential of the marriage penalty.  This new ruling should lower the tax burden for many gay couples in California.  Most gay couples in which one partner earns significantly more than the other will likely get a bump down in tax bracket.  The tax brackets for gay couples in which each partner earns approximately the same should stay the same, so those couples will pay no more (or less) tax.

Frankly, the new ruling is disadvantageous (and potentially discriminatory) to California heterosexual couples because they cannot register as domestic partners, unless one partner is older than 65.  For example, a married couple in which the sole breadwinner earns $250k will be in the 33% tax bracket.  Their gay domestic partner neighbors who have the same income situation will be able to split the income, each reporting $125k, putting each into the 25% tax bracket.  That’s an 8% savings, or $20,000.

At the risk of repeating myself, each family ought to be able to choose how to file their tax forms.  Families that are currently hit by the marriage penalty could choose to file as two singles (or one single and one head-of-household, if there are children).  Gay married couples (like myself) should be allowed to file as married if that would lower their overall tax burden.

Image Credit: Thom Watson at Flickr.

College and the FAFSA

Even though our son is only in first grade, it’s never too early to worry about how we’re going to afford his college education. (After all, it’s a mother’s prerogative to worry). The Free Application for Federal Student Aid (FAFSA) is used by most colleges and universities to determine how much a student should pay towards the cost of his/her education. Many, if not most, middle- and even upper-income families receive some sort of financial aid.

It occurred to me today that since my marriage isn’t recognized by the Federal Government, could I legitimately include just one parent’s income on the form? I’m not trying to cheat, but I do believe that Uncle Sam can’t have it both ways. If they choose not to recognize my marriage (which will (hopefully) be in its 28th year by the time my son starts college) then they have chosen not to recognize my marriage.

Here’s the top of the form:

You can see that the sections are labeled for “Father” and “Mother”.  The federal government isn’t thrilled about citizens crossing out their forms and suggesting helpful annotations.  So what would I do?

A rose by any other name...

The answer, I believe, lies in the fine print at top defining “Parent”.  For the FAFSA, it seems “Parent” refers to the person who has the legal obligation for the student.  This is different, for example, than the IRS who cares more about who actually paid for a dependent’s care, rather than who should have paid.  If the student lived with a grandmother who paid for the care of the student but had not legally adopted him/her,  the grandmother could (probably) declare the student on her income taxes as a dependent, but the grandmother’s income and assets would not be considered for the FAFSA.  I think I get the logic, but it’s worth noting that (at least) two Federal organizations have different interpretations of “Parent”.

My partner and I are both legal parents of our child, so we should (and will) include our financial information.

However, if you live in a state where you cannot legally adopt your partner’s child, then you should feel no obligation to include your financial information on the FAFSA.  This would be small compensation for the lack of formal parental rights.  Imagine your child hurt and in a hospital and you are not allowed to be with them because you are not officially family.   Think about this for five seconds and you will see that paying for your child’s college expenses is a small price for the privilege of actually being a parent.

Summary

For a moment today, I thought I’d found a shortcut to pay for my child’s education.  Further examination into the question, and I realize it is my parental duty to report my income, too, on the FAFSA (even if I have to cross out Mother/Father and write in Thing1/Thing2*).   Finally, I reflect on how lucky I am that I live in a country at a point in history that I can be a parent.  I walk across the room and hug my puzzled son.  I’ll explain it to him someday.

*Tip ‘o the tall striped hat to Dr. Seuss.

Disclaimer: I’m not a lawyer.  I don’t even play one on TV.  This information is presented as educational and should not be interpreted as legal advice.

A. What Happens When You Die

Not to get morbid or anything, but some folks die prematurely. Best to plan now (just in case) rather than later. A last will and testament delivered via Ouiji board will not be admissible in most courts of law.

In the event of your death, the assets in your 401(k) will be transferred into a traditional IRA.  If you had a Roth 401(k) it will be transferred into a Roth IRA.  Everything in this post that refers to an “IRA” also refers to a “401(k).”

B. The Beneficiary Form

The best and simplest way to transfer your IRA assets to your intended heir, is to name him/her/them on the IRA’s beneficiary form.  Keep it updated, and keep a copy.

Not only does the beneficiary form make it clear who gets the money, assets transferred through a beneficiary designation don’t go through probate– they are available immediately to the recipient.  If you don’t fill out the beneficiary form (and if you don’t have a will), your assets are transferred “by law” which usually means that the heirs will be your parents and/or siblings — perhaps not what you had in mind.

C.  Rich Straight People Really Are Different

When a federally-recognized spouse inherits an IRA, he/she can usually just roll the assets over into his/her own IRA account.  The assets grow tax-free until funds are withdrawn in retirement (or until the heir reaches the age of required minimum distributions, 70 1/2).

When a LGBT spouse inherits an IRA, the heir must begin paying taxes on it immediately.  Each year, the heir must transfer a certain percentage out of the IRA (a required minimum distribution, or RMD) and pay tax on it as income.  The percentage is based upon the heir’s age.  When young, the percentage is relatively small but rises as the heir ages.

Not only do LGBT folk miss out on the tax-free growth, but they have to pay the tax during what are presumably their highest-earning years.  This is contrary to the purpose of an IRA which is to defer taxes until retirement when the tax-bracket will (usually) be lower.

In addition a Roth IRA inherited by a spousal heir can be treated as the heir’s own, and the Roth grows tax-free and RMD-free.  A non-spousal heir must begin taking distributions immediately, albeit tax-free, losing all that good tax-free growth.

D. What’s the Financial Impact?

I created a spreadsheet to estimate the financial impact of this additional tax.  If you’d like a copy, please email me.

For the calculation, I assume the LGBT heir is in the 28% tax bracket and receives an average investment return of 4% above inflation.  Each year money is transferred from the IRA to a taxable portfolio at the heir’s RMD rate.  Tax is paid on the investment return of the portfolio and on the RMD’s.  I then calculated the value of the IRA and the value of the portfolio when the heir reaches 70 1/2.

For comparison, I also calculate what the IRA would be worth if it was transferred to a federally-recognized spouse.  It grows tax-free until the spousal heir reaches 70 1/2, at which time she/he also must begin making RMD’s.

Now I could inflate the difference by stopping there, but its not really fair to compare the LGBT heir’s portfolio + IRA to the spousal heir’s IRA, since the portfolio is post-tax, so I discounted the value of the IRA (at a tax rate of 28%).   The post-tax value of the LGBT heir’s retirement savings is lower than that of the spousal heir.  The percentage difference is shown in the chart below:

If your LGBT partner dies when you are 40 years old, you will lose about 10% more of the retirement funds that your partner left you to taxes than you would have if the federal government recognized your relationship.

The impact lessens if the event happens later in life, as there is less time for the IRA to grow.  By age 70 1/2, we all have to take RMD’s, but the disparity does not disappear, as spousal heirs have a lower RMD rate than LGBT heirs.  (Table I vs. Table III of IRS Pub 590).

I did not include the impact of an LGBT heir being taxed during  his/her high-earning years, so this estimate is conservative.

E.  Pension Protection Act of 2006

As bad as this might seem, it was much worse before the Pension Protection Act (PPA) of 2006.   LGBT heirs were not allowed to spread the distributions over their lifetime, but were required to distribute the value of the IRA over five years.  If the inherited sum was considerable, it could bump the heir into a higher tax bracket.  Some employers interpreted the PPA as optional, but the Worker, Retiree and Employer Recovery Act of 2008 made it mandatory.

F.  Strategies

One possible strategy to minimize the effect of this extra taxation is to designate your child as the IRA’s beneficiary.  Children also have to take RMD’s, but at their age, the RMD’s are small and the tax bracket typically low.  In addition, withdrawals for higher education are exempt from the 10% penalty, so you could use the inherited IRA to fund your child’s college education.  There are disadvantages to turning your money over to your children; talk it over with a financial professional if you’re considering this option.

Summary

If you’re a married gay person (or domestically partnered, civilly united, handsfasted, …), you’ll need to take some extra steps to make sure that your assets are distributed in accordance with your wishes.  There’s a financial penalty because the government does not recognize your relationship — both in the loss of the tax-free accrual of the IRA and the requirement to take RMD’s during your peak earning years (and hence higher tax-bracket).  Hopefully you and your loved ones will live a long and healthy life, and you’ll never be put into this situation, but forewarned is forearmed.

Reference: IRS Publication 590:  IRAs

Image credit: Kliefi at Flickr

Carnivals: This post was included in the 242nd Carnival of Personal Finance hosted this week at CashMoneyLife.

Example:  Susan and Carol are expecting a new baby and plan to have Susan stay home for five years until the child enters kindergarten.  Carol has a good paying job and can cover the bills, if they tighten their belts a bit.  Susan previously worked for seven years in telecommunications and has $50,000 in a 401(k) with her former employer.  Susan can transfer the 401(k) funds into a traditional IRA, or as of 2008, you can distribute funds directly from a 401(k) into a Roth.  For each of the next five years Susan can transfer $10,000 into a Roth.  On her 1040, she enters $10,000 IRA distribution on lines 15a and 15b.  Assuming Carol, not Susan, claims the child as dependent (after all, Carol will be in the higher tax bracket), Susan subtracts $5,450 for a standard deduction and $3,500 for her exemption, leaving a taxable income of $1,050.  She’ll owe tax of $106, for an average tax rate of 1%.  Not bad.

You might think we’re getting a great tax break just because Uncle Sam doesn’t recognize LGBT marriage, but remember that we’re missing out on spousal IRA contributions.  Straight couples are allowed to contribute $5,000 to the stay-at-home parent’s IRA (Roth or traditional).  Susan is missing out on $25,000 in additions to her IRA, which could grow to over $171,000, by the time she retires (assuming 25 years at 8%).  LGBT parents — unmarried persons in the eyes of the law — can only contribute to an IRA if they have earned income.

Numbers in this examples are for tax year 2008.

Image credit: Futurowoman at Flickr.

Yeah, me too.

Yet every time I think I’m finished, another issue pops up and nags at me to investigate.

Today’s Quixotic quest was in search of the correct carryover capital losses.

After last year’s market bloodbath, I, and I imagine you, too, have some capital losses (i.e. negative capital gains).  Good news:  they reduce the tax you owe.  Bad news: you can only claim $3000 in losses this year; if you have more, you must carry them over to next year.

The problem is that the carryover amounts are different for myself and my partner on our Federal-filing-single forms than on our Massachusetts-filing-jointly-as-married forms, because some of my losses offset her gains when we file jointly.  When TurboTax imports my form as a starting point for the Pro-Forma Federal married form, it carries in the wrong carryover amounts.

Therefore: I recommend strongly that you record your carryovers on paper (I know that sounds like a Luddite) to make your filing easier next year.  Feel free to use the following format, if you find it useful.

The Federal forms for Pat and Alex individually should be correct.  You can record the values from TurboTax’s Federal Carryover Worksheet.  The values for the Massachusetts state return come from the Commonwealth’s Schedule D, line 22 for long-term loss carryovers and Schedule B, lines 23 or 40 for short-term loss carryovers.  Next year, override the values on the Massachusetts’ Schedules B and D form for 2008 caryovers.

Original post on TurboTax complaints:  Three things I hate about TurboTax