Many married US citizen and/or US resident couples file a joint US income tax return. It is convenient, allows taxation of income at potentially lower tax rates compared to filing separately and may save a small amount of preparation time and professional fees. However, in some situations, filing a joint US income tax return may actually increase a couple’s overall US Federal income tax liability.
Take the example of a couple living in the US near the Canadian border. One spouse works in the US (Mr. A) while the other spouse drives to her job in Canada each day (Mrs. A). While they are both US residents for income tax purposes, Mrs. A is subject to Canadian income tax on her employment income at rates likely higher than US income tax rates. Mr. A and Mrs. A pay mortgage interest and property taxes on their US home and are better off claiming itemized deductions on their US income tax return each year as opposed to the standard deduction.
If they file a joint US income tax return, Mrs. A can reduce the US Federal income tax liability on her income by claiming a foreign tax credit. Since her Canadian tax liability is higher than her US income tax liability, she carries forward to future years the excess Canadian tax not claimed as a foreign tax credit. Mr. A is subject to US Federal income tax on his income.
On their joint income tax return, they claim itemized deductions to reduce their US Federal income tax liability. However, since Mrs. A. will not have US Federal income tax liability anyways due to Canadian taxes being claimed as a foreign tax credit, claiming itemized deductions against her income just increases the amount of foreign tax credit carryover without lowering their overall US Federal income tax liability.
If they file separate US Federal income tax returns, Mrs. A likely won’t have any US Federal income tax liability due to claiming a foreign tax credit for Canadian taxes paid. She likely does not need to claim any itemized deductions or a standard deduction to reduce her US Federal income tax liability to nil. Mr. A. would still be subject to US Federal income tax on his income but can claim all of the family’s itemized deductions assuming that Mrs. A. claims none. By doing this, the full amount of the itemized deductions can go to reduce Mr. A’s US Federal income tax liability. As a result, the family’s US Federal income tax liability may be lower by filing separately compared to filing jointly.
We see this situation with our clients. Recently a Washington state resident couple reduced their annual US Federal income tax liability by approximately $2,500 per year by filing separately.
Written by Steven Flynn, CA/CPA