Divorces are major undertakings. Dividing up jointly owned property and assets, managing custody arrangements for children, and exchanging payments of alimony or child support can all have a significant impact on your life – both emotionally and financially. You should consult a family law attorney for their expertise in divorce matters, however, it is important to recognize that they may not possess expertise regarding tax implications impacting their divorcing clients. Hiring a financial planner in addition to your legal counsel will help you properly address the tax consequences of proposed divisions of property or alimony payments.
1. Alimony is poised to transform divorces in 2019.
Alimony is traditionally fraught with complications and often, resentment. State laws vary widely concerning calculations of alimony, and whether or not one of the parties is eligible. But the federal tax laws have been clear for at least 75 years, easing the pain for at least one party: the paying spouse was allowed to deduct their payments, while the receiving spouse had to account for alimony received as income. But starting Jan 1, 2019, this certainty is gone. The Tax Cuts and Jobs Act, passed in late 2017, has abolished the principle, meaning the payment of alimony is no longer deductible, and the recipient no longer has to pay taxes on it. This makes it more akin to child support payments, where the obligor cannot deduct, and the recipient is not taxed.
The law will apply to divorces finalized in 2019, so divorces finalized before that day will be ‘grandfathered' into the current regime. Still, most family law professionals are apprehensive. Previously, at least the paying spouse had the benefit of deducting this payment, which helped push negotiations along. Now, without any incentive, divorces might be messier, longer and ultimately, more expensive. The recipient spouse might be less able to use the alimony money in retirement accounts like IRA’s, which require payments to be made from taxed income. While there are still many questions about the full extent the tax cuts will have on alimony and divorce, a qualified financial planner can help mitigate any problems stemming from the changes in the law.
2. Know how you will be filing your taxes during and after the divorce.
Most people assume that if you are married for part of a year, you will have to file taxes as married. But, if your divorce is finalized in that year – even on the last day – then you are free to file taxes as a single person. Additionally, you can still file as a couple, but that often does not make sense financially. If one spouse files as head of household, for example, they might receive a boon in tax savings. But, you would have to live separate and apart at least six months, and pay more than half of the costs to the household. The other spouse would have to file single.
3. Understand that the division of assets carries significant tax implications
Divorcing couples need to worry about the actual value of their debts and assets when they begin dividing up their estate. But many assets can affect the tax liability of each party. First, married couples receive a relative windfall on their principal residence if they decide to sell – up to $500,000 gain on their principal residence without incurring a tax liability. Of course, once divorced, then each party can only realize $250,000.00 in the event of a sale. If one party is awarded the property, then they might be entitled to use the mortgage interest deduction. This is only attractive if the house still has an outstanding mortgage, which might not be the case for long-term couples.
4. Lingering taxes after divorce
Wealthy couples or individuals who are self-employed might have to pay estimated taxes, sometimes resulting in an overpayment of taxes owed. If a couple filed a joint tax return in previous years, and the overpayment of tax was applied to any tax owed the year of the divorce, then any overpayment is equally allocated between the spouses. Each gets to benefit from the overpayment, even if one spouse earns significantly more than the other. The same concept applies to joint tax returns filed during the marriage if taxes are still owed. However, courts do have the discretion to determine whether or not one party is assigned the existing liability during the division of property.
5. You need to figure out which parent can claim the child’s tax dependency, or you will be subject to the default rules.
Only one tax return can claim each child on the dependency exemption. If the divorce decree assigns one parent as the primary custodial parent, then by default, this parent will get to use the tax dependency exemption. Generally speaking, the custodial parent is the party who has had actual possession of the child the longest. Courts will be allowed to approve agreements between the parents who might alternate which parent claims tax dependencies each year. For families with multiple children, some parents might agree, for example, that each parent can claim one child in a family with two children. By claiming the dependency exemption, parents stand to benefit from other benefits, like the child tax credit or various education credits. If you have questions about the implications of a divorce on child tax dependencies, it is best to seek out a qualified financial planner in addition to your family lawyer.
6. Retirement accounts have some of the biggest tax penalties if handled wrong.
For long-term marriages, retirement accounts are often the largest assets to be divided up. If done inappropriately, it can carry a tax penalty as well as an early withdrawal penalty, decimating the account. Therefore, for many retirement accounts, like 401(k)’s, if the parties choose to divide the funds, they must be done through a qualified domestic relations order (or QDRO). These essentially allow one party to ‘roll over’ their retirement savings to another without the IRS treating it as a taxable distribution.
If you are in the middle of a divorce, you should seek out expert guidance for every aspect – both legal and financial. Contact a qualified financial planner who can give you comprehensive and competent guidance through the many tax issues associated with a marriage dissolution.
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