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Life and Tax Changes

For every major life change, you'll find associated tax issues. Don't think it's true? Let's see if I can convince you.

A new career
This might be one of the proudest days in your life, a time of new opportunities. Whether it's a part-time job while you're still in high school, or the dream job you accept after receiving your advanced degree, the issues are still basically the same: You'll be given a paycheck by a new employer, and Uncle Sam will take some of that paycheck in the form of income-tax withholding. How much will he take? That'll depend on how you complete your W-4 withholding form.

How should you complete your withholding form? That depends. If you're a student, you may be able to claim an "exempt" status, since your income is so low that you won't have a tax liability. If you have a spouse, children, and a mortgage, you may be able to claim additional exemptions to reduce your withholding. Be sure to pay attention to these factors:

  • Filing status: Are you single, married, head of household, married filing separate, or a qualifying widow/widower? How you file will affect your desired withholding.

  • Children/dependent status: Do you have kids? If so, it's possible that you'll qualify for the Child Tax Credit. Do you have to pay a babysitter to watch your child while you (or you and your spouse) are working? If so, you may qualify for the Dependent Care Credit. And if you're on the lower end of the wage spectrum, you might also qualify for the Earned Income Credit, in which Uncle Sam actually gives you back more in withholding than you've paid in. If you have a dependent other than a child (such as a parent), other deductions and/or credits might also apply to you.

  • Other income/deductions: Do you have substantial other income, such as interest and dividends? If so, you'll have to adjust your withholding to make up for that additional income. How about deductions? If you have a mortgage or are otherwise able to itemize your deductions, you can adjust your withholding allowances upward to reflect your lower tax liability. Starting to pay off those student loans? Some of the interest you pay just might be deductible, so you'll want to adjust your withholding allowances accordingly.

Marriage
It may be the happiest day of your life, but you should understand that marriage is also an economic partnership, especially in the eyes of Uncle Sam. Issues to consider include:

  • Marriage penalty: In many cases, if both spouses work, the couple will pay more in taxes than two single people with the same incomes. While the new tax law has partially addressed this inequity, it hasn't completely been extinguished.

  • Adjust withholding: Because of the marriage penalty, it's imperative that you check your withholding status immediately. Too many newlyweds have found themselves in hot water on April 15 of the year following their marriage, owing a ton more in taxes that they had expected. When they were single, they would both get refunds, but their marriage has brought them a hefty tax bill. It's all due to the filing status, the law, and the amount of withholding from both spouses' paychecks.

Divorce
This, in turn, could be one of the saddest days of your life. But just as a marriage is an economic union, a divorce is tantamount to an economic divestiture. Tax issues here include:

  • Filing status: Your filing status will obviously change, and you'll want to make sure that your withholding follows your new filing status.

  • Other income or deductions: With the splitting of marital assets, your other income (such as interest and dividends) will change dramatically. Likewise, it's possible that mortgage interest will be divided or eliminated completely. Other assets (such as rental properties) will also be divided, and the tax impact will follow the person who retains the property. There may also be some forced sales of assets that could generate capital gains.

  • Timing and character of filing: Remember that your filing status is based on the last day of the year. If you're still legally married on Dec. 31, you have the option of filing a joint return. If you're single as of Dec. 31, you are no longer allowed to file a married-joint return, which means some planning is in order. If you've been living apart, and there are young children involved, it's possible for one or both spouses to claim head-of-household status.

  • Alimony and child support: Remember that alimony is generally taxable to the person receiving it, and deductible by the person paying it. On the other hand, child support is not taxable to the spouse (or children) receiving the payments, and not deductible by the person making the payments. This fact alone will have a substantial impact on your tax and financial life, not to mention how your divorce agreement is negotiated.

Leaving your job
If you're retiring, you're likely ecstatic. But if you're leaving for another job (or have been asked to leave by your employer), the experience might be more bittersweet. Keep these tax issues in mind:

  • Retirement plan distributions: What should you do with them? If you're simply changing jobs, it's probably best to transfer your retirement assets -- such as a pension and/or 401(k) plan -- to a traditional rollover IRA. If you move the funds into your personal account, they will be subject to taxes, and possibly penalties. But if you transfer them to a traditional rollover IRA, you can avoid current taxation. Even better, in an IRA, you're in control of your investment decisions, not some mutual fund manager. It's also possible that you can move your retirement assets directly from your old employer's plan to that of your new employer.

  • Retirement payments: If you take your retirement as an annuity, rather than a lump sum, make sure to review your withholding again. It's possible that your tax bracket will change, and you'll have to understand how your new tax rate will affect the taxes (and withholding) on your retirement funds. Alternately, you might opt not to have any withholding taken from your retirement payments. In that case, become aware of how estimated taxes work, and how to play that game to avoid underpayment penalties.

  • Social Security: If you're fortunate enough to retire, it's possible that you'll be receiving Social Security payments. Did you know that, at certain income levels, up to 85% of your Social Security benefits will be taxable? If this is a surprise to you, you might want to read more about the taxability of Social Security benefits.

Virtually every life event will affect your taxes in some way. Even if your life isn't changing, the tax laws are. It's up to you to be vigilant in keeping as much of your money as you possibly can.

Fool contributor Roy Lewis is a very old person and has endured many life-changing events. He can attest firsthand to the tax impact of all of them. One of Roy's biggest life-changing events was hooking up with The Motley Fool, where he learned that it's all aboutinvestors writing for investors. You can take a look at thestocks Roy owns, as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.


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