Over the last year, matrimonial lawyers have reported an uptick in clients seeking information about divorce. Additionally, divorce-related keyword internet searches are up by 11%, with nearly twice as many people searching “file for divorce online” and 14% more people typing “I want a divorce,” according to data analytics company SEMrush, since the onset of COVID. These couples seeking divorce report that spending most of 2020 being cooped up together, 24/7, exposed deeps cracks in their marriage.
Now, married couples are facing even stronger headwinds against staying together. The tax proposal just released by the House Ways and Means Committee on Sept. 13 provides a peek into what the bill may look like in its final form. While there are many tax changes, the most notable include raising income and capital gains tax rates on high earners – especially married couples. Wedded individuals will see the most dramatic tax squeeze, so as a result, getting a divorce could save high-earning couples thousands of dollars or more in taxes.
Marriage Penalty Multiplies
The bill includes restoring the 39.6% top marginal rate and a host of new tax increases on single individuals earning $400,000 or married couples earning $450,000. Currently, the highest marginal tax rate tops out at 37%, which kicks in when individuals make more than $523,600 annually and with couples earning more than $628,300, causing what is known as the "marriage penalty."
The American Families Plan proposal amplifies the marriage penalty that comes into play when the taxes a couple pays exceed what they would have paid if they had remained single with the same incomes. The marriage penalty is not a new concept, but the Biden plan increases the tax squeeze. If you look at the proposed tax brackets in the recently released “Green Book,” which is the updated version of Biden’s tax plan, you'll notice that the brackets for married filing jointly (incomes above $509,300) are now a meager $56,500 higher than those of single filers (incomes above $452,700) before they fall into the top ordinary income tax rate of 39.6%. This will create a significant tax bite for married couples, making divorce more financially appealing now.
For example, two single filers who make $400,000 would find themselves in 35% tax bracket. If those same two people were married and filed as "Married, filing jointly," their total income would be the same $800,000. However, $290,700 of that income would be taxed as the higher 39.6% rate, resulting in thousands of dollars in extra taxes.
The House Ways and Means Committee’s proposal calls for tax rates on long-term capital gains to also rise from 20% to 25% for individuals earning $400,000 and married couples earning $450,000, enacting a stiff marriage penalty yet again. This 25% rate would be the highest top rate imposed on long-term capital gains in the last 25 years.
Should You Really Get a Divorce, for Tax Purposes??
To save on taxes, will financial advisers recommend couples increase savings for their children’s college education, max out their work 401(k)s … and get a divorce? Avani Ramnani, Managing Director of Francis Financial and divorce financial specialist, explains that she cannot see herself recommending clients get divorced due to taxes. However, Ramnani shares that "if the couple is already in the divorce process, it makes sense to make them aware of the tax savings they might experience if they complete their divorce sooner than later."
Seth Kamens, CPA and managing member of accounting firm Feder Kamens, cautions that getting a divorce just for tax reasons is not a good idea. Kamens shares that “Revenue Ruling 76-253 states that the IRA will disregard a divorce obtained solely to save money on taxes. The couple must recalculate their taxes as if they had stayed married for the entire year, making the couple liable not only for additional taxes but also for interest and penalties. Couples over the threshold may also explore filing taxes separately, but often useful tax deductions and credits are disallowed.”
While the ink on the bill is still not dry, experts like Kamens and Ramnani agree that couples should discuss their tax strategy sooner than later. The changes in tax brackets are not expected to go into effect until 2022 at the earliest, giving couples time to plan. However, the capital gains rate increase may go into effect immediately. This means that people with significant unrealized capital gains would not avoid the higher tax rate by selling these assets before the end of 2021.
Tax-Management Strategies – No Divorce Required!
Ramnani recommends that couples reduce their taxable income by maxing out their retirement plans at work and participating in employer-sponsored savings accounts for child care and health care. It would also be wise to speak to your financial adviser about tax-loss harvesting with your investments.
Workers with 401(k) or 403(b) retirement plans can make pretax contributions up to a maximum of $19,500, ($26,000 for those 50 and older.) Because contributions are made pretax through paycheck deferrals, the money saved will lower taxes with the added benefit of increasing retirement investments.
A flexible spending account (FSA) can also save you money because it allows you to pay for unreimbursed medical expenses with pretax dollars. An employee can contribute up to $2,750 during the 2021 plan year.
A health savings account (HSA) allows pretax contributions to be used for health care costs not covered by insurance. However, this account is only available to employees with high-deductible health insurance plans. Contribution limits are up to $3,600 for individuals and $7,200 for families for 2021.
Ramnani adds, “Both HSAs and FSAs provide for a reduction in tax bills during the years in which contributions are made, making them savvy tax-savings opportunities.”