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5 Tax Moves to Make Now if You Just Got (or Are Getting) Divorced

By Dan Caplinger - Nov 13, 2017 at 4:34PM
A bride and groom figure are pointed in different directions

5 Tax Moves to Make Now if You Just Got (or Are Getting) Divorced

When spouses part ways

Apart from being one of the most traumatic and stressful experiences in life, getting divorced also has huge financial impacts . In particular, divorce can change your tax situation dramatically, and it's critical to take steps to prepare for those changes as soon as possible.

The following tax moves will help you adapt to your new financial reality following a divorce.

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1. Prepare for your new tax filing status

One surprise for many divorced spouses is that the IRS requires them to change their tax filing status. When you file your tax return for a given year, your marital status as of Dec. 31 of that year will determine which filing status you can use. In other words, even if you don't divorce until late in the year, you'll be treated for tax purposes as if you had been unmarried throughout the year, so you won't be able to file as "married filing jointly" or "married filing separately."

Whether the change in filing status will cost you money or save you money depends on your specific financial situation. In general, however, single-earner couples see the biggest increase in taxes when they switch to filing as unmarried taxpayers, while dual-income couples with roughly equal earnings are most likely to see a tax decrease.

You'll also need to determine whether you qualify for favored head of household status, as well as whether you'll need to coordinate with your ex-spouse to claim the tax benefits that being head of household gives you.

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A female child holds a drawing of a home while her parents are behind her looking upset.

2. Figure out who will claim tax breaks for children

Parents who are divorcing also have to figure out who will be entitled to claim the tax credits, exemptions, deductions, and other benefits that are attributable to their children. Children play a key role in major tax breaks like the Earned Income Tax Credit, the Child Tax Credit, and the Child and Dependent Care Tax Credit, and most children are entitled to a personal exemption to reduce taxable income on a parent's return. Later on, education-related credits are also important for students and parents.

In some cases, only the custodial parent is allowed to claim the tax break. However, other situations allow divorced ex-spouses to work together to determine the best way to allocate tax breaks across the two ex-spouses' tax returns. Factors to consider include each ex-spouse's future tax liability and the relative benefit each would get from various tax breaks.

That said, it's critical to ensure that both parents respect the best interests of the child regardless of the tax consequences, rather than letting the IRS be the primary consideration in child-related custody and financial issues.

ALSO READ: Can Divorce Destroy Your Retirement?

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3. Structure alimony and child support in a tax-smart way

Often, one ex-spouse makes payments to the other after a divorce. Those payments can be structured as a combination of alimony and maintenance,  as well as child support for couples with children.

Under current law, alimony payments are deductible for the paying ex-spouse but must be included as taxable income by the receiving ex-spouse. Maintenance and child support, on the other hand, are neither deductible by the payer nor included in income by the recipient. Make sure your divorce decree explicitly states the nature of any payments to be made, taking into consideration the tax impacts. Also keep in mind that the latest tax reform proposal would change the treatment of alimony to match up with other divorce-related payments, taking away deductions and income inclusion.

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4. Handle the family home as soon as possible

Divorcing couples who own a home have an extra complication to think about. If both ex-spouses decide to move out and sell the property, then they'll typically qualify to take the capital gains exclusion on sales of personal residences. However, there's a two-year residency rule, so if you delay, you could lose exemptions of up to $500,000 on gains from the sale of the property.

Meanwhile, couples also have to account for future taxes if one ex-spouse decides to stay in the home. Single owners only get a $250,000 maximum exemption, so taking into account future tax liability can be especially critical in high-priced real estate markets that have seen healthy price increases over the course of the couple's ownership of the home.

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 A young couple holding two halfs of a picture of a heart over their faces

5. Avoid tax penalties when splitting retirement savings

Retirement plans have become a major financial asset for many Americans, and in a divorce, retirement plan assets can be a critical source of financial support for an ex-spouse -- especially one who didn't work during the marriage. However, you don't want to simply take money out of a 401(k) or similar plan, because the immediate tax consequences are costly.

Instead, a Qualified Domestic Relations Order allows divorcing couples to split up retirement plan assets in a tax-favored way. Under a QDRO, money can be taken from one ex-spouse's retirement plan and put into a separate account for the other ex-spouse. This account has the same tax advantages as the original owner's account, including tax-deferred growth on any assets that remain in the account.

In retirement, the owner of the new account will owe taxes on money distributed from it. There's a set of requirements you must fulfill to comply with the laws governing QDROs, so it pays to get help where you need it.

ALSO READ: Getting Divorced? Here Are 4 Ways Your Taxes Will Change

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Be tax-smart about divorce

In the middle of a divorce, you may find it difficult to focus on the tax implications. Down the road, though, you'll be glad you kept these issues in mind and took steps to protect yourself in your new and independent financial life.

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