Tax filing status becomes much more important when you have large amounts of student loans. If you are single, you will not have any complications to worry about. If you are married, thoughtful analysis might be needed to find the most optimal filing status.
What are the tax filing statuses?
Generally, when you are married, Married Filing Jointly (MFJ) is the preferred status to use on your tax return. This is because it will usually provide a lower overall tax rate and allow numerous tax deductions and credits. When you use MFJ the incomes of both spouses are added together to determine total income and taxes for the year. MFJ is used by the majority of married couples.
The other married filing status is Married Filing Separately (MFS). It is far less common due to the fact that the income brackets are compressed and many deductions and credits are disallowed. In other words, most people will pay more in taxes using a MFS return than on a MFJ return. When you use MFS, you will complete two tax returns. Each return only contains the income of the identified spouse. It’s almost like you are completing two single filing tax returns.
When you add large amounts of student loans to the picture, things become more complicated. It might even make sense to use the uncommon MFS tax filing status.
How do tax brackets work?
Tax brackets are often confusing, so it might be worth a quick explanation of how they work. When someone says your marginal tax rate it refers to the tax rate on your next dollar earned. The US tax system using a progressive tax so that not all of your income is taxed at the same rate. The current brackets in 2023 are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
At the beginning of each year, you start with no income. As you begin to earn money during the year, the lowest tax bracket fills up first. Once the lowest bracket is filled, it will then overflow into the next highest bracket. This means you will have a little bit of income taxed at 10%, a little bit taxed at 12%, and so on depending on how high your income goes. Imagine buckets being filled with water (income). Once the top bucket (10% bracket) fills it will then overflow into the next bucket (12% bracket).
What are the downsides to MFS?
From an income tax perspective, MFS is disadvantageous for a couple reasons. The first reason is the narrower tax brackets. The tax brackets for MFS are almost identical to the single tax brackets. For example, $180,000 of income in the MFS brackets pushes your marginal tax rate up to 32%. The same $180,000 in the MFJ brackets is only a marginal rate of 24% with plenty of room on top of that.
If you and your spouse make identical incomes, the tax burden will be identical for MFS and MFJ. Generally, the wider the income gap between spouses, the more disadvantageous MFS is.
The second reason is disallowed credits and deductions. The most common disallowed items include the following:
- Child and dependent care credit (includes things like daycare expenses)
- Adoption credit
- American Opportunity Tax Credit and Lifetime Learning Credit (for education expenses paid during the year)
- Student loan interest deduction (for interest paid during the year)
- Phaseout* of the child tax credit is half that of MFJ
- Capital loss deduction is half that of MFJ
- Traditional IRA contribution deduction phaseout* is much lower
- Cannot directly contribute to a Roth IRA
*A phaseout is the gradual reduction of a credit or deduction from the maximum allowable to zero as income increases through the phaseout income range.
Why should you consider MFS?
There can be substantial disadvantages to MFS from a tax perspective. However, the effect that MFS can have on your student loan payments could outweigh those downsides.
When you use an Income Driven Repayment (IDR) plan, your payments are based on your Adjusted Gross Income (AGI). The lower your AGI, the lower your monthly payment will be. If you plan to seek loan forgiveness of any kind, your goal is to make the lowest monthly payment possible. If you and your spouse both earn an income then your AGI together will be higher than if your incomes are separate.
Common Law States
Example: you are the dentist and earn $200,000 and your spouse earns $100,000 (we will pretend there are no other sources of income or deductions for simplicity). On a MFJ tax return your AGI would be $300,000. On a MFS return your AGI as the dentist would be only $200,000.
Community Property States
Example: you are the dentist and earn $200,000 and your spouse earns $100,000. On a MFJ tax return your AGI would be $300,000. On a MFS return your AGI is calculated by adding the incomes of both spouses and dividing by 2. Each spouse would show income of $150,000 on their MFS return. In a community property state, there is no income gap on a MFS return due to the equalizing of income. Therefore, the direct income tax disadvantages of MFS are minimized.
When you are able to exclude a substantial amount of spousal income, the income tax disadvantages of MFS are countered by the savings you make on student loan payments. If the net benefit of lower student loan payments is greater than MFS tax disadvantage, then it is worthwhile to use MFS.
The MFJ benefits are not lost forever though. You can amend prior (up to 3 years prior) year tax returns back to MFJ and receive the benefits back. This is beyond the scope of this article and will be discussed at another time.
Should you file MFS?
You will likely only be using MFS if you are pursing forgiveness. All of the following scenarios take this into account.
If you have a spouse that earns income, MFS should be considered.
If you and your spouse have student loans, MFS should be considered.
If you and your spouse have student loans, and you live in a community property state, MFS should be considered.
If you live in a community property state, and you earn more income than your spouse, MFS should be considered.
If you are using the REPAYE plan, MFS will generally NOT be useful because REPAYE considers the income of both spouses no matter how you file taxes (this could change in 2023 depending on the Biden administration proposed revisions to the REPAYE plan).
The decision to file taxes separately from your spouse should not be taken lightly. There are many considerations that need to be evaluated. When you and your spouse have student loans, things can get even more complex. This is when working with a student loan professional can be increasingly valuable.
Remember, a tax return can be amended from MFS to MFJ but not from MFJ to MFS.