We're not talking about in-laws.  We're talking about the inadvertent tax penalty that many couples face simply by being married.  In these days of "family values," marriage penalty relief has been a high priority of many in Congress, yet nothing has been done.

A marriage penalty occurs when a married couple pays more income tax than they would if they had filed as two unmarried persons.  According to a study by the American Institute of Certified Public Accountants, there are at least 63 provisions in the Internal Revenue Code where tax liability depends on whether a taxpayer is married or single.

However, two specific provisions cause the most problems.  The standard deduction for single filers is generally about 60% of the standard deduction for married couples filing jointly.  So, in 1999, a married couple would receive a standard deduction of $7,200; an unmarried couple would receive two standard deductions of $4,300 for a total of $8,600.

People with higher incomes are concerned about the disparity in the tax brackets.  For 1999, a married couple hits the 31% bracket at $104,050 of taxable income, while an unmarried couple won't reach it until $124,900 of income.  The tax brackets for single filers are also generally "wider," meaning that they have more of their income taxed at one rate before jumping up to the next one.

The inequity becomes most evident at the 39.6% bracket.  Both married couples and single filers hit this bracket at $283,150 in 1999.

The marriage penalty severely affects couples where both earn a comparable income.  The Joint Committee on Taxation reports that married couples whose earnings are split more evenly than 70-30 often suffer a marriage penalty.  Couples where one spouse earns virtually all of the income actually receive a marriage "bonus" because they get a higher standard deduction and tax brackets.

Despite the fact that a few more couples actually receive marriage bonuses than marriage penalties, many in Congress have made alleviating the marriage penalty a tax-cut priority.  But, it doesn't come cheap.  The Congressional Budget Office estimated the marriage penalty brought in nearly $29 billion in 1996.

The Conference Agreement in this year's tax bill contained provisions to slowly increase the standard deduction for married couples and to eventually expand the lowest tax bracket for couples.  Unfortunately, ideological differences between the Republicans in Congress and President Clint on gave the bill no hope of passage.  We may see some scaled back provisions this year.  Stay tuned-we'll keep you posted on any developments on Capitol Hill.

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Everyone dreams of sending their kids to college, but skyrocketing costs have made this increasingly difficult.  Congress created tax breaks such as the Hope Credit, Lifetime Learning Credit, and student loan interest deduction.  However, they don't provide incentives to plan and save for college.

The new Education IRA, a custodial account that allows you to withdraw funds tax-free to pay qualifying college expenses, has an annual contribution limit of only $500.  So, even if you contribute the maximum for 18 years at 10% interest, you'll still end up with only about $23,000.  That may not buy much education in 20 years.  And, using an Education IRA withdrawal precludes you from using the Hope Credit or Lifetime Learning Credit.

Fortunately, most states offer a college funding plan (See the chart below).  While each state's plan is unique, they share common traits.

Common Traits

A state tuition plan is set up naming a child as the beneficiary.  If the account balance isn't used, a member of the child's family can become the beneficiary.  Generally, anyone can make contributions to the plan on the child's behalf because there are no income limitations.

The states must impose some limit on plan contributions.  The states must also impose penalties on amounts withdrawn that are not used for qualified expenses, which are generally defined as tuition, books, fees, and limited room and board.  However, some states may place their own restrictions on expenses covered under their plans.

Earnings on contributions to state tuition plans avoid federal income taxation until the funds are withdrawn.  Many states don't subject qualified plan withdrawals to state income tax; some states also allow a limited state tax deduction for contributions.  Usually, withdrawals from these types of plans can be used in the same year as the Hope Credit or Lifetime Learning Credit.

One misconception about state tuition plans is that they can only be used at colleges in that state.  While a few states may restrict where you can spend it, most states allow you to use the account at any accredited institution.  However, some states do require you to be a resident to set up an account, and tax exemptions and other state tax benefits may not be available to out-of-state plans.  You won't receive the tax benefits from another state's plan if you don't file a tax return in that state.

Types of Plans

Generally, state tuition plans come in two forms:  a prepaid tuition plan and a college savings plan.

In a prepaid tuition plan, you enter into a contract to "buy" tuition at current levels, either in a lump sum or in monthly installments.  Alternatively, the plan may have you buy credits, with a certain number of credits required for a year's tuition, room and board, etc.  If you enter into a contract to buy 4 years of tuition, tuition is guaranteed regardless of how much the cost has escalated.  However, if the return earned on your investment exceeds what is needed for expenses, some states limit how much of that extra return you will see.  So, prepaid tuition plans work best if you expect college costs to escalate at a faster rate than you can earn on your money.

College savings plans work like an IRA.  You simply make contributions to the plan and they grow tax-deferred.  Contribution limits are designed to prevent the account from accumulating far more than will be needed to pay college costs.  There's no guarantee that you'll build up enough to cover all of the expenses, but if the investments do really well, you can roll over the excess earnings to a family member.

Unlike an IRA, these plans are not self-directed; they are administered by the state or its designated agent.  Look at the historic returns of the plan and compare them to the after-tax returns on your own investments.  Even without the tax breaks, you may earn a better return on your own.

Wading through all of the different incentives and options can be challenging.  We can help you evaluate the alternatives.

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STATE TUITION PLANS