Samuel and Felicity, Revisited
One move would really cut taxes for the Times’ fictional couple
Remember Samuel and Felicity, the fictional couple from Bronxville, N.Y., that the New York Times created to illustrate the effects of the December 2017 tax law on middle-class couples? The Times initially said that Samuel and Felicity would owe $3896 more in taxes under the new law; it later revised its calculation to acknowledge that Samuel, who is self-employed, could claim the new section 199A qualified business income deduction, which would leave him and his spouse owing about $40 less than under the old law. One puzzled tax professor still couldn’t understand why the Times didn’t have Samuel and Felicity claim an additional $1500 in dependent credits, which would lower their tax bill further. And then the world moved on . . . .
Turns out there is another move that Samuel and Felicity could make to lower their tax bill by more than $2000. And it’s a move that quite a few upper- and middle-income couples, especially in higher tax blue states, could use in the coming years to achieve substantial tax savings.
Notwithstanding news reports that suggested that the December 2017 tax law had eliminated marriage penalties for all but the very rich, two features of the law produce marriage penalties (or divorce bonuses) for middle- and upper-middle-income couples: the larger standard deduction and the $10,000 cap on deductions for state and local taxes (SALT). The financial circumstances of Samuel and Felicity illustrate how these operate.
Here’s how I’ve calculated it. If Samuel and Felicity are married and file jointly, then they will have total income of $183,911 ($95,000 from Felicity’s salary plus $89,454 for Samuel’s business income plus $236 in taxable interest plus $864 in qualified dividends minus $1643 in capital losses). Various above-the-line deductions, all attributable to Samuel’s business, bring their adjusted gross income down to $160,964. They will have to choose between claiming a standard deduction of $24,000 or itemizing deductions. Reverse-engineering the Times’ calculations, it appears that they pay state and local income and property taxes of $17,554, which puts them well above the $10,000 SALT cap. Still, with $34,867 of mortgage interest and charitable contributions on top of $10,000 of SALT deductions, they’re better off itemizing. Adding in the $17,891 deduction for qualified business income from Samuel’s solo consulting business, they have taxable income of $98,206, which lands them in the 22% tax bracket (15% for capital gains). Their tax, before accounting for various credits and Samuel’s self-employment tax, is $13,424.
What if Samuel and Felicity divorce but continue to cohabitate? The first thing they should do is make sure it’s Felicity who pays their mortgage interest, makes their charitable contributions, and pays enough of their property taxes so that her share of property taxes plus her state income taxes total $10,000, and that Samuel pays all other household expenses. They want to make sure that more than half of household expenses are paid by Samuel so that he can claim head of household status. A back-of-the-envelope calculation suggests that this should be doable, even with Felicity paying mortgage interest and most of the property tax bill. Let’s say they bought their home for $750,000 with a 20% down payment and an interest rate around 4.5%, and that they pay about $10,000 a year in property taxes. The interest (as opposed to principal) component of their mortgage payment will fall below $25,000 a year after the first few years, and Felicity — who will likely pay in the range of $4000 in state income taxes on her salary — will hit the SALT cap if she chips in $6000 for property taxes. So Samuel just needs to clear $31,000 to claim head of household status. Let’s say he pays somewhere in the range of $24,000 a year for groceries for a family of five, $2000 for cable and utilities, $3000 for property insurance, and $4000 in remaining property taxes. He’s already at $33,000, without considering other sundry household expenses (furniture, kitchenware, repairs, etc.). Samuel and Felicity should obviously run the numbers themselves before they follow my advice, but because they’re fictional characters, I’m not too worried about a legal malpractice claim.
I’ll assume that Samuel and Felicity split their assets evenly in divorce so that each gets half of their taxable interest, dividends, and capital losses. Felicity ends up with adjusted gross income of $95,544, and itemized deductions of $44,867 (mortgage interest plus charitable contributions plus $10,000 of state and local taxes). Her taxable income is $50,677, and she’ll file as single, putting her in the 22% bracket for ordinary income and 15% for long-term capital gains and dividends. In her case, this yields a tax of $7058, before accounting for credits.
Samuel’s adjusted gross income, meanwhile, is $67,051. He should file as a head of household and claim the $18,000 standard deduction. His qualified business income deduction is capped at 20% of his taxable income, so he can deduct $10,135. This leaves him with taxable income of $38,916, which puts him in the 12% bracket for ordinary income and the zero bracket for long-term capital gains and dividends. In his case, this yields a tax of $4346, before accounting for credits (and in his case, self-employment tax). Felicity and Samuel’s combined tax (Felicity as a single filer, Samuel as a head of household) is $11,404, which is $2020 less than what they paid when they were married.
As for the rest of the tax calculation: Samuel can claim more generous educational credits as a head of household than the he and Felicity could have as a married couple because his modified adjusted gross income is below the American Opportunity Tax Credit phaseout range for a head of household and the couple’s modified adjusted gross income was in the phaseout range for married-filing-jointly taxpayers. We don’t have quite enough information about tuition payments to nail down the savings, but this suggests that $2020 is an underestimate of the federal tax benefit that Samuel and Felicity can achieve through divorce.
There are still state tax issues to consider, though based on my quick calculation, it looks like the couple would save an additional $139 in New York state income taxes through divorce. And of course, there are lots of non-tax factors that affect decisions to marry and unmarry (or ought to). The point of this post is not to urge Samuel and Felicity to end their union (though if they do, they should finalize their divorce before December 31, 2018, so that Felicity can deduct alimony payments to Samuel and the couple can shift income from the 22% bracket to the 12% bracket). It’s to emphasize four points, with one final note.
— Marriage penalties remain for middle- and upper-middle-income couples notwithstanding Republicans’ ostensible efforts to eliminate them. (For more on this, see the Tax Foundation’s informative and aesthetically pleasing visualizations and the Tax Policy Center’s do-it-yourself marriage bonus/penalty calculator.) This is in addition to the well-known marriage penalties embedded in the earned income tax credit.
— The effort by congressional Republicans and the Trump administration to roll personal exemptions into a set of larger standard deductions — weakly justified on simplification grounds — has the curious effect of increasing marriage penalties. That’s because the benefit of having one member of a couple file as a head of household is larger when the head of household standard deduction is $18,000 than when it was $9350, as under old law.
— The $10,000 SALT cap, evidently intended as a gut punch to blue states, strikes an even harder blow against married couples in the blue states where the cap is most likely to bind, since it’s the same $10,000 cap for married couples filing jointly as for single filers and heads of household. Backers of the December 2017 tax law have offered absolutely no explanation for the uniform $10,000 cap (reduced to $5000 for married individuals filing separately). An effort to get blue states to stop practicing the family values that red states preach?
— And I meant what I said when I complimented the Times’ Samuel-and-Felicity infographic back in February, notwithstanding the paper’s initial arithmetic error. It’s a fantastic teaching tool that keeps on giving.
On a final note: Marriage penalties in the Code — especially marriage penalties for taxpayers with children — may be a feature, not a bug. Marriage remains a powerful indicator of ability to pay. Or put differently: Single parent status remains a powerful indicator of reduced inability to pay. Using marital status to tag single parents for redistributive transfers may make a lot of sense from an equity perspective. And marriage penalties are a necessary corollary of targeted transfers to single parents. I’ll have more to say about this in a paper soon. I doubt that this is what the Trump administration and congressional Republicans intended, but there may be a silver lining nonetheless.