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Going from Two Incomes to One, or from One to Two When you start a family, you may decide that one parent should stay home with the children, or one of you may need to go back to school. Suddenly, you go from two incomes to one.

You know you face a tight budget, but depending on how much you were both earning, the change may mean you get a lower tax rate, more deductions, and more credits, so your tax bill could possibly drop dramatically.

On the other hand, perhaps you are thinking that it is time for one spouse to return to work, after having been out of the workforce for a while. Income will go up, but probably, so will taxes.

Here are some areas where the change from two incomes to one, or from one income to two, may affect your taxes.

  • Tax rate
  • Limits on deductions
  • Dependent Care Credit
  • Child Tax Credit
  • Becoming a Full-Time Student
Tax Rate
Depending on how much each of you can earn, eliminating one spouse's income may lower the family's marginal tax rate.

Example: What If One Spouse Stops Working?
For 2002, a family with one child in which each spouse earns $80,000 per year and has average deductions probably ended up in the 30% federal tax bracket. This means that every dollar earned by this family was taxed at 30 cents on the dollar, and a significant increase in income could have moved the family income up to the 35% bracket. If one spouse stopped working, though, the family would shift down to the 27% tax bracket (a 3% decrease in taxes), and the family would have a fair amount of room in the 27% bracket before being pushed up to the next level.

Example: What if You Earn Different Amounts, and One Quits Work?
Imagine a scenario in which one spouse earns $130,000 and the other spouse earns $20,000. As in the example above, the family income puts them into the 30% bracket. But, if the spouse earning $20,000 stopped working, their income would not go down enough to drop them into the next lower tax bracket. There would be no decrease in the marginal tax rate.

When you are thinking about adding or removing one spouse's income, then, take a look at the way the change affects your total income as a family, and therefore your tax rate. Your rate depends on your filing status (married filing jointly, married filing separately), and your taxable income. Generally, at each tax bracket, you pay a fixed amount, plus a percentage of your income above a certain level.

Limits on Deductions
Switching from two people earning income to just one will reduce your total income, but it may also allow you to take more off your taxes in itemized deductions, because you may no longer exceed the income limits set for the phase-out of particular deductions. You end up with less income, but possibly more deductions.

Example: Deductions
The family described above in which both spouses earn $80,000 is subject to certain deduction limitations. Let's assume that the family has a total of $15,500 in itemized deductions from $12,500 in mortgage interest, $2,500 in real estate taxes, and $500 in charitable donations. Unfortunately, they cannot deduct the entire $15,500 on their Form 1040 because their $160,000 income exceeds the $137,300 limit, which also limits their itemized deductions under current tax law. As a result, their total deduction is reduced to $14,819. As your income gets higher, your reduction amount also increases, which lowers your ultimate deduction. Of course, if the couple had only one income of $80,000, the itemized deductions would not be reduced at all.

Other deductions depend upon the level of income you receive:
  • The personal and dependent exemption deductions, presently $3,000 per person, begin to phase out after a married couple's income reaches $206,000.
  • Medical expenses are deductible to the extent that they exceed 7.5% of your adjusted gross income (line 35 of Form 1040). The family with $160,000 in income must have medical expenses totaling over $12,000 before they get any tax benefit from those expenses. On the other hand, a family with income of $80,000 sees a tax benefit from any medical expenses over $6,000.
  • Miscellaneous itemized deductions (those taken on Schedule A lines 20 through 26) are deductible only to the extent that they exceed 2% of your adjusted gross income.
  • If you are married and paying interest on student loans, you can take a deduction of up to $2,500 for interest paid during the year, but only if your joint income is under $130,000.
  • A deduction for contributing to your IRA is available only to married couples with a combined income below $64,000 for 2002, if both spouses are already covered by retirement plans at work.
Dependent Care Credit
The dependent care credit is designed to provide partial tax relief for dual-income families with children who require care while their parents work. Families with one or more children in day care are eligible for a tax credit as high as 30% of care costs up to specified limits. As the total income rises, the credit percentage bottoms out at 20% of care expenses.

A credit is great because it reduces your tax, dollar for dollar. Most dual-income couples can take a credit of $600 for one child or $1,200 for two or more children.

When one spouse does not work outside the home, the couple loses eligibility for the credit, even if they incur some childcare expenses. (One exception: a spouse who is not working, but becomes a full-time student.)

If you are a stay-at-home parent considering a return to work, you must weigh any day care costs you will incur, reduced by the amount of the Dependent Care Credit. Form 2441 contains the steps for computing the credit. For details, see the Instructions for Form 2441.

On the other hand, if you or your spouse's employer offers a dependent care benefit program in which up to $5,000 of your childcare costs are paid from pre-tax dollars, this may be a more tax-efficient way to handle your child care costs. If your combined income puts you into the 30% tax rate bracket and $5,000 of your income is diverted to pay child care costs instead of paid as taxable income, your tax savings is $1,500 compared to $600 or $1,200 in tax savings via the tax credit.

Child Tax Credit
The Child Tax Credit is available to families with children under age 17, regardless of whether one or both parents work. The credit is $600 per child, and it is available in full to married couples whose adjusted gross income is at or below $110,000 (you report your adjusted gross income on line 33 of Form 1040).

The credit begins to phase out after your income exceeds that amount, and the point at which it disappears completely depends on the number of children you have. For example: the family with one child earning $160,000 per year would receive no child tax credit.

Becoming a Full-Time Student
If one spouse plans to quit work to return to school full-time, a few other provisions in tax law come into play, because taxable income goes down when a spouse quits work, all of the issues discussed above apply except for one twist with the Dependent Care credit.

Normally, both spouses must earn income in order to qualify for the Dependent Care credit. Plus, the total expenses qualifying for use in computing the credit cannot exceed the earned income for each individual spouse. However, if one spouse attends school full-time, that spouse is considered to have earned income in an amount equal to $200 per month of school attendance for one child or $400 per month for two or more children. Thus, if a nonworking parent returns to school full-time for the entire year and the couple incurs at least $4,800 in outside care expenses, the nonworking parent is considered to have earned $4,800 for the year for purposes of the credit. In this way, the couple can take advantage of the Dependent Care credit even when only one spouse works.

Another benefit available to families with one spouse attending school full-time is income eligibility for the education credits.

Also, if one of you attends school full time, your income may drop so dramatically that you can qualify for one or both of the education credits: the Hope credit, and the Lifetime Learning credit. You may get as much $1,500 per year if the student spouse qualifies for the Hope credit, and $1,000 per year if he or she qualifies for the Lifetime Learning credit.
  • Example One Spouse Goes Back to School
    When both spouses earn $80,000 each, the couple would not be eligible for either of the education credits because their combined income exceeds $100,000. However, if one spouse quits work and returns to school full-time, their income drops below that limit, and the couple becomes eligible for the credits.

    Their tax liability goes from $34,256 to $11,657 when you take into account their new tax bracket, lower income-related deduction limits, and eligibility for the education credits. If the family includes children, add in eligibility for the Dependent Care credit, and the Child Tax credit.

  • Deducting Interest on Student Loans
    If the couple gets student loans, the interest on those loans may also be deductible. If you have been paying interest on your student loan, you can deduct up to $2500 of that interest from your income, but figuring out how much you can deduct may make you feel like you are taking a surprise quiz in math class.

  • Deducting Higher Education Expenses
    You can deduct some of a spouse's expenses for tuition in college or graduate school, for the years 2002 through 2005.
    • You can take the deduction even if you do not itemize your deductions.
    • Your expenses do not have to total a certain amount before you can take the deduction.
    • The deduction is not limited by the overall limitation on itemized deductions.
    • You can study whatever you want, except sports, games, and hobbies; and you can even study those if the classes are part of a degree program.