Tag Archives: Registered Domestic Partners

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

26 Monday Nov 2012

Posted by in Marriage, Retirement, Taxes

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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].

  1. The money can be pulled to pay for health insurance premiums for an unemployed taxpayer or their spouse.
  2. The money can be pulled to pay for higher education expenses for the taxpayer or their spouse.
  3. 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.

Social Security Issues for Self-Employed Registered Domestic Partners in Washington

15 Wednesday Feb 2012

Posted by in Community Property, RDP Tax Returns, Social Security, Taxes, Washington

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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.

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

24 Tuesday Jan 2012

Posted by in Community Property, RDP Tax Returns, Taxes, Washington

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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.