Life Changes Are Tax Changes

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By Roy Lewis
August 10, 2001

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. And that's true regardless of whether it's a part-time job while you're still in high school or the dream job that 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 Sammy 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 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 such that you won't have a tax liability. If you have a spouse, children, and mortgage, you may be able to claim additional exemptions that will reduce your withholding. Some of the things that you should especially be aware of include:

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

Children/dependent status: Do you have kids? If you do, it's possible that you'll qualify for the Child Credit. Do you have to pay a baby sitter to watch your child while you (or you and your spouse) are working? If so, you'll 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, whereby Uncle Sammy actually gives you back more in withholding than you've paid in. And if you have a dependent other than a child (such as a parent), there might be other deductions and/or credits that might apply to you. 

Other income/deductions: Do you have substantial other income, such as interest and dividends? Then you'll have to adjust your withholding in order to make up for that additional income. How about deductions? If you have a mortgage or otherwise are 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 that you pay just might be deductible, so you'll want to adjust your withholding allowances accordingly.

Marriage

Perhaps the happiest day of your life. But understand that marriage is also an economic partnership, especially in the eyes of Uncle Sam. Some of the issues that you should 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, the relief won't kick in for a little while.

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. They owe a TON more in taxes that they had expected. Heck, when they were single, they would both get refunds. But now that they are married, they have a hefty tax bill. It's because of the filing status, the law, and the amount of the withholding from both spouses' paychecks.  

Divorce

Quite possibly 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. And there are tax issues that you'll want to be aware of, which include:

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

Other income or deductions: With the splitting of the 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. And there may be some forced sales of assets that might generate capital gains.

Timing and character of filing: Remember that your filing status is based on the last day of the year. So if you're still legally married on December 31, you have the option of filing a joint return. If you're single as of December 31, you are no longer allowed to file a married-joint return. So 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. So you'll have a number of choices and alternatives.

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

This could run the gamut of feelings. 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 joy might not be as great. Regardless of your feelings, the tax issues are many and include:

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 IRA. If you take the funds, they will be subject to tax and, possibly, penalties. But if you transfer them to a traditional IRA, you can avoid current taxation. But even better, in an IRA, YOU control your investment decisions, not some mutual fund manager. It's also possible that you can move your retirement assets from your old employer to your new employer.

Retirement payments: If you take your retirement as an annuity rather than a lump sum, make sure you 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 impact the taxes (and withholding) on your retirement funds. Or you might opt to not have any withholding taken from your retirement payments. In that case, become aware of how estimated taxes work, and how to play that game in order 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? Read Taxation of Social Security Benefits for more information.

So, see? Virtually every life event will have an impact on your taxes in some way, shape, or form. 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. And you can learn more about all of the tax issues noted above by visiting the Tax Center or checking out our new Crash Course, The Tax Cut and You. Give 'em a look -- it could change your life. 

Roy Lewis is an old person, and has had many life-changing events. He can attest first-hand as to the tax impact of all of them. One of Roy's biggest life-changing events was hooking up with The Motley Fool and learning that it's all about investors writing for investors. You can take a look at the stocks 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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