Implications for MFJ vs MFS
You found “the one”, you fell in love with the one, you married the one and you are grateful that THIS one doesn't have a bunch of federal student loans like you do. But then you realized that your income, when combined with the income of your spouse, is going to more than double your AGI. That’s great for the grocery budget, but it is also going to increase your monthly loan payments by quite a bit.
You have been making qualifying, income-driven payments towards PSLF but now you risk that the jump in monthly payments could wipe out the loan forgiveness you have been expecting. So what do you do? You do your taxes, because you have to. But you also research whether choosing the “Married Filing Separately” filing status may be better for you than the more common “Married Filing Jointly”. Every married couple is legally allowed to file separately. But should you?
“Married filing separately” allows you to isolate your income from your spouse’s for purposes of determining your monthly loan payment under certain payment plans. This might allow you to lower your monthly payments and thus, maximize your future forgiveness. But there are tax implications and loan repayment plan considerations you need to be aware of.
Repayment Plan Considerations
Borrowers eligible for the PSLF program (and who do indeed end up receiving forgiveness) have strong incentives to keep their adjusted gross incomes (AGI) as low as possible. This is because a lower AGI results in lower total loan costs over the life of their loans. Of the 4 federal income-driven repayment plans, only REPAYE requires taking your spouse’s income into account for the purposes of determining your monthly loan payments. The other three plans (PAYE, IBR, and ICR) allow you to isolate your income if you chose to file “married filing separately” rather than jointly with your spouse.
The tax laws specifically state that a married couple may choose to file jointly or separately based on whichever filing status is the most beneficial to them. Most couples end up filing jointly, because many deductions and credits are disallowed when filing separately. And taking away these deductions typically makes filing separately the more expensive option. However, there are indeed many couples for whom filing separately actually lower their taxes.
How to Decide
So how do you decide whether filing separately is the right thing for you? The short answer is that there is no short answer. You have to do your taxes three ways (yours separately, your spouse’s separately, and jointly) and calculate how much extra tax you pay (or save) by filing separately. There are too many variables, and generalities are difficult.
For a borrower expecting PSLF, the decision on what to do is easy once the math is done: Choose (or switch to) a non-REPAYE plan and file separately if your annual loan payment decreases by more than the increase in your tax. Your overall cash-flow for the year will be higher, and your future loan forgiveness will exceed the “penalty” you paid (if any) by filing separately. For example, if filing separately costs you $1000 in extra taxes, but lowers your annual payments by $2000, then you will end up with an extra $1000 in your pocket for the year and will have paid $2000 less over the life of your loan upon forgiveness.
But be very careful and focus on a critical assumption! Paying extra tax to lower your payments and minimize your overall total loan costs is a “sure thing” only if you end up getting PSLF in its current form. What happens if for some reason you become ineligible for PSFL? Suppose you end up in a non-qualifying job, or perhaps the PSLF rules are changed and you are not “grandfathered-in”?
In this case, any extra tax you pay by filing separately is gone forever, and will have had no positive impact on your loans. On the other hand, many existing borrowers are confident enough in the PSLF program to take this risk. Especially if the overall extra tax paid by filing separately is small.
But there are situations where you may choose to pay (a little) extra tax even when you are not planning for PSLF. Filing separately will lower your monthly payments. Without PSLF, this simply delays the amount you eventually have to pay (with interest). However, if you have other higher interest debt (credit card debt, for example), you will come out ahead by directing the extra cash flow to that debt.
Alternately, you may decide to invest the extra cash flow you received by filing separately in your (or your spouse’s) employer plan such as a 401k/403b (to take advantage of a match, for example).
The point to remember is that you have the option to file separately and lower your payments. And you can simply calculate the extra tax (if any) you will pay as well as the resultant decrease in payments, to see if the benefits to you of filing separately exceed the costs.
Estimations and Assumptions
Although we said that making generalizations regarding the penalty/benefit of filing separately was hard, we can estimate the tax hit to you for a small set of situations. The first table below estimates the extra tax you will pay if you file separately based on a set of simplifying assumptions:
- You and your spouse only have income from a regular job
- You have no children
- You live in a state with no income tax
- You would not itemize your taxes if filing jointly
- You pay $2500 in student loan interest a year (which is the maximum amount deductible)
The amounts in bold at the left and at the top represent the wages reported to you on W-2 (basically your salary after subtracting items like health insurance and 403b/401k contributions). Numbers in red represent the extra amount of federal income tax you will pay if you file separately. Green numbers are the amount you will save on taxes by filing separately.
The main purpose of the chart is simply to show you how the tax you pay varies based on both the total income as well as the difference in income. Note that changing any of the first 4 assumptions above will likely increase the extra tax due, and thus the chart below might be considered the “best-case” scenario.
Loans plus Tax
As you can see, many salary combinations result in extra tax when filing separately. However, most couples with student loans come out way ahead when taking the reduction in loan payments into account. The table below displays the yearly “savings” to the typically borrower with federal student loans on an income-driven plan. The values in the table represent the net benefit achieved when filing separately.
For example, look at the situation where each spouse makes $75,000. You’ll seen the net benefit of $7279. This represents a decrease in loan payments (and thus an increase of loan forgiveness) of $7500 obtained from excluding $75,000 of spousal income, minus the tax “penalty” of $221 from filing separately. You’ll note that for all combination of incomes, filing separately is a net positive.
Remember, these tables represent the best case scenario, because they do not include state taxes, nor do they take into account the tax effects that children have when filing separately. There is no substitute for doing your taxes 3 ways (yours separately, spouse’s separately, joint) and comparing the results. You can do this with just about any software package, or you can have a tax professional help you. But hopefully you understand the general concept, and can figure out for yourself whether to file jointly or not.
One word of caution regarding filing separately. We at DOCTORED MONEY have seen multiple cases where taxes filed separately were incorrectly prepared. The most common mistake occurs because people don’t realize that both spouses must choose the same method when choosing between the standard deduction and itemized deductions. That is, each spouse has to itemize, or each spouse has to choose the standard deduction. So even though you are both filing “separately”, your taxes remain linked in a manner of speaking.
Tax software is set to choose the best method (standard vs itemized deduction) for your individual case. But in the case of filing separately, the software does not take into account the other spouse’s method. Therefore, one frequently has to override this feature and manually select the appropriate option, based on whether it’s cheaper for both spouses to take the standard deduction, or both to itemize. You’ll have to essentially calculate it both ways (4 ways?) if filing separately to choose what’s best for you in the context of this particular restriction.