Divorce affects all aspects of your life, and it has definite financial implications at tax time. Many tax laws hinge on marital status, and so you need to understand the impact that divorce has on your taxes. Below, we tackle how your taxes change when you get a divorce.
The most obvious change on your tax return when you get divorced is the change in filing status. The IRS looks at whether you were married on Dec. 31 to determine whether you need to file as a married or single taxpayer. As a result, those who divorce late in the year are treated as unmarried for the entire year, while if you got divorced in Jan. 2016 or later, you'll still need to file your 2015 return as a married couple.
Whether the change in filing status adds or subtracts from your total tax liability depends on your particular situation. Basically, if you suffered from what's known as the marriage penalty because of your joint income, then divorce can reduce your taxes. Those who earned a marriage bonus because of large disparities in the two spouses' income will generally see taxes rise after divorce. However, if you have children and qualify for head of household status, it can dramatically reduce your taxes compared to simply filing as a single taxpayer.
Dealing with family tax breaks
If you have children who qualify as tax dependents, then one key question will be which parent gets to claim the exemption for those children. Not only do exemptions get you a reduction in taxable income of $4,000 per child for 2015, but they also help drive which parent can claim lucrative tax credits. For instance, the Child Tax Credit pays up to $1,000 per child, and educational credits for eligible expenses can offer as much as $2,500.
The custodial parent will typically have the inside track for claiming a dependent and getting the associated credits, but non-custodial parents can sometimes claim exemptions if the custodial parent agrees. For some tax breaks, such as the Child and Dependent Care Credit, only the custodial parent is eligible regardless of what the two parents would prefer.
Alimony and child support
If you agree to alimony payments, then the paying ex-spouse gets to deduct those payments. The receiving ex-spouse must include them as taxable income.
By contrast, payments for child support don't have any tax impact. Neither the payer nor the recipient has to include them or deduct them on their tax returns.
Dealing with the home
Joint filers are eligible to exclude as much as $500,000 from the sale of a personal residence. But for single taxpayers, that exclusion falls to just $250,000.
That works out fine if both ex-spouses agree to sell the home quickly, because both will likely be able to take their respective $250,000 exemptions. But two problems often come up. If both ex-spouses move out of the home and it takes a long time to sell, then a failure to meet the two-year residency rule over the preceding five years can reduce or eliminate the exemption. Also, if one ex-spouse gets the property in the divorce settlement and later sells it, then the total available exemption will be cut in half. It takes smart planning in the divorce settlement to make sure that both ex-spouses reach a result that makes them comfortable.
Handling retirement accounts
Often, one of the biggest assets a couple has is one ex-spouse's 401(k) account. You can't just take money out of those accounts and transfer it to the other ex-spouse, or else it will be treated as a taxable distribution with potential penalties.
What you can do though is to get what's known as a Qualified Domestic Relations Order, or QDRO, from the court handling the divorce. The QDRO authorizes your employer to transfer the agreed portion of your 401(k) account to your ex-spouse without any tax consequences. The receiving ex-spouse will then be subject to any taxes on withdrawal later on. Technically, a QDRO isn't necessary for IRA transfers, but many financial institutions prefer to have a court order on file.
Divorce has huge consequences, and the financial ones can come as a shock. Knowing in advance what will happen in divorce is crucial to avoid unnecessary financial disruptions.