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 and adapt to those changes as soon as possible.
The following tax moves will help you stay aware of and plan for the many issues that you'll have to deal with in your financial life following a divorce.
1. Prepare for your new tax filing status
One surprise for many divorced spouses is the required change in their tax filing status. The IRS requires you to use your marital status as of Dec. 31 in determining eligibility for a given filing status, and so even if you didn't divorce until late in the year, you'll be treated for tax purposes as if you had been unmarried throughout the year.
Whether the change in filing status will cost you or save you money depends on your specific financial situation, but generally, single-earner couples see the biggest increase in taxes from filing as unmarried taxpayers after divorce, while two-earner couples with roughly equal incomes are most likely to get a tax decrease. In addition, you'll 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.
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. Yet 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.
3. Structure alimony and child support in a tax-smart way
Often, one ex-spouse makes payments to the other after 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 by the paying ex-spouse and 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.
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 that applies to the rule, and 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.
5. Tackle retirement plan accounts in a tax-smart way
Retirement plans have become a major financial asset for many people, and in a divorce, splitting up retirement plan assets can be a critical source of financial support, especially for ex-spouses who didn't work while they were married. However, you don't want to just take withdrawals out of a 401(k) or similar plan, because the immediate tax consequences and penalties 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 account 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 while money remains in the retirement plan account. In retirement, the ex-spouse will owe taxes on money distributed from the account. There are key requirements to comply with laws governing QDROs, so it pays to get help where you need it.
Be tax-smart about divorce
In the middle of a divorce, it can be tough to worry about 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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