US Videos

A Tax Checklist for Same-Sex Couples

Jason Stipp

Michael Kitces is a Partner and the Director of Research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.

Jason Stipp: I'm Jason Stipp for Morningstar. The Supreme Court's 2013 decision striking down part of the Defense of Marriage Act, known as DOMA, has created some planning opportunities and a few questions for same-sex couples.

Here to walk us through some of the important highlights is financial planning expert Michael Kitces.

Michael, thanks for calling in today.

Michael Kitces: Great to be here. Glad to join you.

Stipp: When DOMA was originally struck down, the basic notion was that if a same-sex couple had gotten married in a state that recognized that marriage, their marriage would also be recognized by the federal government. What wasn't addressed was whether a state that does not recognize a same-sex marriage would be required to recognize a marriage that happened in another state. Right now, they don't have to recognize that.

So, there were some questions about, if a same-sex couple got married in Massachusetts and moved to Indiana, what would happen to their federal benefits in that case? Have any of those issues been clarified since the decision?

Kitces: Great question, Jason. We've seen some clarification. Here's basically what it comes down to: When we look at all the different provisions that apply to married couples in the law--and by some estimates, there are literally more than a thousand different rules and laws out there that in some way, shape or form mention the word marriage. This question has lingered, what exactly does marriage mean? And if you get these conflict of law situations, like, I got married in a state that recognizes the marriage and I live in a state that doesn't, whose laws are we supposed to use?

Historically that didn't matter, because with heterosexual couples, we had some pretty clear uniformity across states as to what constituted marriage. With same-sex couples, this has become more complicated. All the federal decision did, all the Supreme Court decision really did, was state that the federal government must acknowledge whatever the state acknowledges. The federal government is not allowed to override the state. That was the actual portion of DOMA that got struck down.

What we got left with is this continuing rule-by-rule or state-by-state patchwork that says, some states will acknowledge the marriage only if it's legal in their states. We call that the state of residence rule. Other states will simply say, as long as the place that you got married, it was a legal marriage there, we will recognize your marriage here as well. That's often called the place of celebration rule.

What we've seen going through the federal laws now is different parts of the federal government are actually coming to different conclusions. So, the IRS came forth with one decision; they said, we'll follow place of celebration, which means as long as it was legal where you got married, we'll recognize it as legal. Other parts, like Social Security, have gone a different direction.

So, it really does remain a little bit of a patchwork, because truly, it's just hard-wired into the law, some rules used one definition, some rules used the other. Some rules were flexible enough that the government can just shift its direction and say we're going to follow this one now. And other rules, we can't technically change without an act of Congress, so it may be much slower to get them all aligned.

Stipp: Setting aside the issues of couples needing to figure out some of these state-by-state issues that will affect their planning Let's assume that a same-sex couple does live in a state that recognizes. Now, the federal government will also recognize.

Let's talk about some of the planning issues that should be on their radar that they may want to be taking advantage of. You're talking about income taxes there. So, the option to file a joint income tax or married filing separately. What are some reasons why couples will want to make sure that they're filing in the right way, now that they can file as a couple.

Read Full Transcript

Kitces: Same-sex couples where their marriage is recognized and are making this joint filing decision, we have to break it into two categories. What we can do going forwards and what we can do going backwards.

Going forward, for better or for worse, is the simpler one. If the couple is married and the marriage is now recognized under a law, they are a married couple, they will be filing a joint tax return. There is no choice otherwise, except the standard rule for every married couple, which is instead of doing married filing jointly, you can do your married filing separately with, frankly, all of the adverse things that tend to come with married filing separately. Our tax code doesn't make it very hospitable to do so.

We do, every now and then, see situations where couples have extremely large differences in income, where the math actually works to do married filing separately. But in most situations, virtually all of them that we see, you are now a married couple, you will be filing a joint tax return.

Ironically, for some of them it's actually not good news. If you have two people who earn a pretty healthy income, your tax bill as a married couple may actually be higher than it was as two singles, but going forward, you don't have a choice. You are married; you need to file a joint tax return, either married filing joint, or married filing separate if the math works for you.

The messier situation is going backward. The challenge for a lot of same-sex couples is basically they've been married for years. They never filed joint returns in the past. Now they are recognized as being married, and they are recognized as being married retroactively back to their original marriage date. So it raise this question, should I actually go backward and amend my old tax returns to say, hey, it turns out I was married for tax law purposes after all; I'd like to file an amended return.

And the IRS has opened this up. As it stands right now, you don't have to go backward and file an amended returns, but you can choose to do so. And it becomes pretty straightforward for the couples that we've worked with on this. We go back and run the numbers. If it turns out that you would have owed more, you won't go back and file. If it turns that you would have gotten a refund, you go back and file and you get your refund.

And there is a little bit of ambiguity right now about how much can we cherry-pick? Can we do 2012, but not 2013, and there is some discussion about how much flexibility we have. But we've seen a number of couples where it actually made sense going back three years--that's the maximum we can go backward and amend--and so we're going through the process right now of filing three years' worth of amended returns, and they will get a rather sizable refund check for several years' worth of higher income taxes they were paying as two single people that they could avoid by being a married couple.

Stipp: Gift and estate taxes are another area that same-sex couple will want to take a closer look at, and the estate tax was the essential issue in the Windsor case, that was the DOMA case. Talk about some of things you would be looking at in that situation.

Kitces: On that forward-looking basis, again, two big areas. From the gift tax perspective, life just got a whole lot easier. The challenge for same-sex couples in the past was, even just supporting each other financially was technically deemed by the federal government as gift. All of that's off the table now. You are a married couple. You can manage your household finances on a married basis without any issues around gift taxes.

In terms of estate planning, it means you now need to update you estate planning documents as a married couple. So, we see a lot of same-sex couples now completely revising their estate planning documents to take advantage of all of the rules that are available for married couples, including portability of the exemption and just a lot of planning flexibility that we give to married couples.

Now here, too, we have a backward-looking option as well. We've had clients who were transferring property between themselves had to file gift tax returns in the past and are now going back three years and amending the gift tax returns to say, well actually, since we are married all along and now the government recognizes the marriage, we would like back our gift taxes or the credits we had to use to absorb the gift taxes.

And likewise--and this was the case, as you noted, for Windsor itself--if a same-sex couple was legally married and one of them passed away, and there was an estate tax paid for leaving money to the survivor, that survivor can now go back and file an amended estate tax return, as long as it happened in the past three years, and actually get their estate taxes refunded to them. In Windsor's case, that was a $363,000 windfall.

Stipp: Social Security is another area where traditionally married couples have spent some time planning. Those planning options are now available to same-sex couples. So what are the big things that they should be thinking about in Social Security planning?

Kitces: Social Security planning has been a little bit messier. Unlike the tax code, which said if your marriage was legal where you got married, we're not going to worry about where you live right now. Social Security is a little bit harder; they are still following a full state of residence rule, which means you've got to actually live in a state that recognizes the marriage.

Now, if you are a same-sex married couple, and you are eligible for Social Security, and you are living in a state that recognizes the marriage, you can go ahead and apply for spousal benefits as a married couple, and do all of the normal planning strategies that are out there for Social Security for married couple: file and suspend, and restricted application, and coordinating benefits between the two of you.

If you are living in a state that doesn't recognize the marriage, though, technically you are in limbo land right now. The Social Security Administration hasn't unequivocally said, we will never pay benefits to you. What they basically said is, if you try to apply, we're going to put you on hold right now, and we're trying to see if we can figure something out for you.

The guidance that President Obama gave when the DOMA case happened was, he essentially gave a directive, an administrative order, to all federal agencies that said, to the extent possible, please use the place of celebration rule that just recognizes married couples based on where they got married, not what state they happen to live in now.

Some agencies were able to adopt that quickly. The Social Security Administration has been a little bit harder, because some of their rules are actually hard-coded into the laws around Social Security. So, it's a little bit messier in the case of Social Security. If you live in a state that recognizes the marriage, you are fully treated as a married couple. If you live in a state that doesn't, you're still in a holding pattern right now to find out how they are going to handle it.

Stipp: With respect to IRAs, individual retirement accounts, there could be some planning options, including the ability for spousal IRA contributions. What would a same-sex couple want to explore with respect to IRAs or inherited IRAs?

Kitces: So again here, there are two versions: what we do for people who are alive and what we do for people who have passed away. For folks who are alive, frankly, there is a little bit of IRA planning opportunity; it's not big. We can do things like spousal IRA contributions now. The normal rules for IRAs say you have to have earned income from employment, self-employment, or wages in order to make an IRA contribution. For spouses, you can make an IRA contribution based on your spouse's earnings, even if you don't work outside the home. That is now an option that's available for same-sex married couples. So, they may be able to do a little bit more IRA contributions, even if one of them doesn't work.

The bigger opportunity, frankly, is from the estate planning perspective. If someone passes away and leaves an IRA to a same-sex partner, when the marriage wasn't recognized, you were treated as any other unrelated beneficiary, which meant you have to start taking the money out over your life expectancy beginning immediately, the year after the person passed away.

For spouses, we give an additional option called the spousal rollover rule, which says you can take the inheritance from your spouse and roll it into your own IRA and hold on to it all the way until you turn age 70 1/2, and then you just begin distributions based on your own account balance and your own rules.

That spousal IRA rollover option is now available. So, from a prospective perspective, we see people now adjusting their estate plans to recognize that IRA rollovers will be possible, so we maybe don't need some of the insurance trusts and other vehicles that we had in place before, because we weren't going to be able to roll over that IRA.

Again, for people where someone had already passed away, if you have a same-sex spouse, you were legally married, that person passed away at some point in the past, and you have an inherited IRA from them, you are now suddenly able to do a spousal rollover with all the money that's still in the IRA. You can't go back and get the money that you already pulled out in prior years, but you could stop your required minimum distributions and roll it over to your own account, and then manage that on your own basis going forward. We've seen a handful of situations where a survivor is looking at doing that.

Stipp: Michael, I've reviewed the work you've done on same-sex planning opportunities on your blog in light of the DOMA decision; it's very detailed and really outstanding work.

Thanks for joining us today and giving us some of these highlights.

Kitces: My pleasure. Happy to be of service.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

Read more on this topic from Michael Kitces: