Getting divorced is a major life event, and the financial consequences of divorce are wide-ranging and extensive. Many of those financial impacts will show up on your tax return, and understanding the options available to you can save you money at tax time if you use the right tax strategies. Below, we'll look at the key tax issues that divorce affects the most.
1. Your filing status will change
First and foremost, when you are no longer married, then your filing status will change. The key date for determining marital status for filing purposes is Dec. 31. If you were still married on that date, then you'll need to file your return as a married person, even if your divorce becomes final before your tax return is due. Conversely, if your divorce was final before Dec. 31, then you'll file as an unmarried taxpayer for the entire year -- even if you were married for the vast majority of the period.
By itself, a change in filing status doesn't necessarily say whether you'll pay more, less, or the same in taxes as you did when you were married. Some couples face a marriage penalty, where they pay more as joint filers than they would if they hadn't gotten married in the first place. Other couples have a marriage bonus, especially when one spouse earns all or most of the family's income. In those cases, the higher-earning ex-spouse can often see a dramatic increase in tax liability upon divorce.
Also, special filing status can help produce tax savings. The most important is the head of household status, which applies to single and divorced parents who pay more than half of household expenses for a qualifying child or dependent. Tax brackets are wider for head of household filers than for single filers, and that can produce additional tax savings that some divorced parents don't realize are available.
2. Couples with children will have to sort out tax breaks
Another tax issue that divorcing parents have to address is who will be entitled to take various tax credits and deductions attributable to their children. In general, the custodial parent often has a leg up over the non-custodial parent in claiming things like the personal exemption for a child, the Earned Income Tax Credit, and the Child Tax Credit for parents. With some provisions, such as the Child and Dependent Care Tax Credit, only the custodial parent can claim the tax break.
In some cases, divorced spouses can work together to figure out the best allocation of tax breaks. For instance, if one ex-spouse is in a higher tax bracket than the other, then that spouse will get more savings from taking a tax deduction. Similarly, one ex-spouse might not have enough tax liability to take advantage of nonrefundable tax credits. With personal exemption amounts of $4,050 for 2016, Child Tax Credits amounting to $1,000 per child, and various other tax provisions that can help you save thousands more, it's important to get these tax issues right even if it causes some stress between the divorcing parents.
3. Figuring out alimony, maintenance, and child support payments
In a divorce, one ex-spouse often ends up making payments to the other. How those payments get characterized makes a key difference. For alimony payments, the paying ex-spouse gets a tax deduction, while the receiving ex-spouse has to include the payments as income. The same is not true for maintenance and child support payments, which have no tax impact.
Again, your divorce decree will generally state the nature of payments. It's important not to see those issues as unimportant, because they can make a big difference in terms of what you get after taxes.
4. Get your home situation resolved quickly
One issue that comes up in divorce situations is what happens to the family home. If both ex-spouses move out and the property is sold quickly, then the two-year residency rule for capital gains exclusions on personal residences typically applies to both ex-spouses. That brings the total exemption up to $500,000. If more than two years goes by, then the exemption is lost, and that can create a huge capital gains tax bill.
Also, if one ex-spouse receives the home, the couple needs to figure out how to deal with future tax liability. Going forward, the ex-spouse owner will only have the $250,000 exemption for unmarried filers rather than the couple's $500,000. That can be a problem in pricey real estate markets where sales prices have climbed through the roof lately, and so ex-spouses should plan for the future by accounting for one ex-spouse's future tax bill.
5. Be smart with 401(k) retirement plan accounts
With many couples, 401(k) accounts or other employer-sponsored retirement plans make up much of their joint savings. The issue is so common that lawmakers came up with a way to split 401(k) and similar accounts pursuant to divorce by using what's called a Qualified Domestic Relations Order.
The QDRO allows for the creation of a separate account for an ex-spouse that sustains the tax advantages of the retirement plan. No tax impact occurs when the QDRO is funded, and thereafter, the ex-spouse who received the funds will be responsible for any taxes due on withdrawal during retirement. Make sure that you comply with all of the requirements that the employer and financial institutions involved need in order to get the division of retirement assets done correctly.
It's important to treat the financial aspects of divorce seriously, because the tax impact can be surprisingly large. Preplanning is essential in order to avoid shocking problems that you didn't anticipate.