Divorce and Taxes
Divorce has become an everyday reality in the United States. If you're planning to get a divorce, you should pay close attention to your short- and long-term tax exposure before you divide marital assets.
For instance, divorcing, but still married, spouses will save money if they file their taxes jointly. Read on to learn about the effects of divorce on taxes and your estate plan.
How Does Divorce Affect Taxes?
After a divorce, you need to remember:
- To give your employer a new W-4 form and Employee Withholding Certificate (you have 10 days to turn this form in)
- Alimony payments set after 2018 are not deductible by the payer
- You will submit a married filing tax return until the divorce decree is final
- Your tax implications will change after divorce and you may not save as much money
- Until you are officially divorced, your spouse's financial decisions will have tax consequences on you. If you suspect illegal activity or financial harm, speak with an attorney right away.
Can Divorce Reduce Your Taxes?
Generally, your taxable income, tax deductions, and tax brackets are given tax breaks while married. A divorce agreement will take away many of the benefits of filing jointly.
Once you file separate returns, there will be different standard deductions and tax refunds. You can speak with a tax advisor to see how your marital status will change your tax situation.
Filing Taxes When a Divorce Isn't Final
Until the divorce is final, you are legally married. You should continue to file a joint return unless you have a final decree of divorce before the tax year's last day.
If you get a decree of annulment, you need to file an amended tax return for every tax year affected by the annulment. This is usually around three years because the statute of limitations closes after three years.
You also can legally separate or live separately from your spouse during a divorce. In these cases, you may be able to file as "head of household." Your divorce attorney should be able to answer your filing status tax questions while the divorce is in progress.
Who Owes on Back Taxes After Divorce?
The back taxes you owe will be split up, and each person pays according to their taxable income, assets, and tax deductions. If your ex-spouse makes more money than you, it is likely they will need to pay more. As an example, if you make $40,000 and your ex makes $80,000, you would not split the back taxes 50/50. You would pay less because of your income (unless you have significant assets).
Splitting the back taxes is helpful if you have tax debt after divorce. It allows each party to pay a percentage and does not throw your ex's taxes all on your shoulders. To split your back taxes, you need to fill out IRS Form 8857.
Joint Custody: Who Claims the Children?
Unless there's a court decree stipulating otherwise, the custodial parent is entitled to the dependency exemption (which can be released through IRS Form 8332). Only the custodial parent may take the child care credit, but both parents may able to deduct medical expenses, regardless of custody.
If you are the custodial parent, you can claim the children if:
- The divorce or separation is legal, or you have lived apart for six months during the tax year
- Your kids received six months of financial support from you
- You had your kids in your primary home for six months (or more) out of the entire year
- You did not sign away your rights to claim your children
If you and your ex have a 50/50 split of custody, then the custodial parent is the one with the higher income.
If an ex-spouse claims the child on their taxes illegally, you should speak with a tax professional about the next steps. It is illegal for your ex to claim them if you are the custodial parent.
Transfer of Assets Between Spouses
The IRS generally doesn't consider the transfer of assets between divorcing spouses a taxable event. As long as you can demonstrate that divorce was the reason, you can transfer cash and assets between you and your divorcing spouse tax-free. But if you and your spouse have accumulated assets such as mutual funds, stocks, bonds, or artwork, you can be subject to a large capital gains tax bill when you attempt to divide them.
For example, when you buy stock shares from your spouse, the cost of that stock (for you) has risen. However, you'll still be taxed based on the capital gain earned between the time you and your spouse purchased the stock at the original price and when you sell. Meanwhile, your ex-spouse doesn't need to pay taxes on the money you paid to buy the stock from him or her.
Taxes on Selling Your Home
For most couples, their home is their most valuable jointly-owned asset. Typically, upon divorce, you have three options:
- Sell the house and split the proceeds immediately;
- Sell the house and split the proceeds sometime in the future; or
- Allow one spouse to buy out the other's interest in the property.
You can avoid paying capital gains taxes on the profits from your home sale if you reinvest the home sale proceeds within two years. The home must be your principal residence, meaning you have lived in the home at least three years out of the last five.
Divorced spouses can have a difficult time meeting this requirement when the settlement allows one spouse to remain in the home for more than two years before it's sold. The ex-spouse not residing in the home can then lose their eligibility to avoid the capital gains tax, so it's something to consider when working out an agreement.
Retirement Funds and Taxes During Divorce
Retirement funds can be treated as marital property during a divorce settlement, so you may have to share retirement funds (including Social Security) with your spouse. If your spouse has a right to a portion of your retirement funds, you must adhere to the applicable tax laws when you make distributions. You are not allowed to "alienate" or "assign" your qualified pension plan distributions to anyone else.
Qualified Domestic Relations Orders (QDROs)
If you have retirement funds that you must share with your spouse upon divorce, you should obtain a Qualified Domestic Relations Order (QDRO). A QDRO is a court order detailing the proper procedure for the distribution of your retirement benefits in the future.
It allows your benefits plan administrator to proceed with distributions as if you're still married to your ex-spouse. This ensures that both parties receive their rightful benefits.
The QDRO also resolves any issues that may arise if you or your ex-spouse remarry. Current and ex-spouses each receive a proportionate share of the plan distributions.
Individual Retirement Accounts (IRAs)
Upon divorce, IRAs are generally considered the sole property of the original owner. However, if you make contributions to your IRA from your earnings during your marriage, your spouse will be entitled to a proportionate amount of IRA assets. The exact distribution amount is subject to state laws.
IRA funds can be transferred tax-free from one spouse to another by a written divorce decree. But if you're the recipient of IRA funds, you can be held responsible for a 20% federal income tax. To prevent this, you need to ask your IRA trustee to roll the funds into your own IRA.
For married couples, filing separate tax returns is incredibly costly. If you and your spouse can agree to continue to file jointly until the divorce is final, you'll save yourself a lot of money.
However, be cautious because if your spouse incurs tax liabilities and penalties, you'll be jointly liable.
Your Estate Plan: Updating Your Will and Power of Attorney
Taxes and property division aren't the only financial considerations during divorce. Depending on how far along you and your spouse are in your estate plan, you'll probably need to make a few updates to protect your finances. This would include updating any powers of attorney you have in place.
You'll also want to update your will. And even though you're getting divorced, you may still want to leave your ex-spouse with something. Some states revoke all gifts left to your spouse in your will automatically upon divorce. If this is not what you want, you may need to be more proactive in your stated intentions.
In some states like Ohio, statutes provide for automatic revocation of any estate plan provisions that mention your former spouse. Be sure to check the applicable laws in your state and make any necessary changes. If you don't, you may find yourself unintentionally leaving property and assets to your former spouse.
Get Professional Help With Divorce and Taxes
If you're dealing with tax issues during your divorce, you'll want the assistance of an attorney experienced in both divorce and tax law. Find a local divorce attorney today.