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Tax Issues During Divorce

 

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  Tax Issues During Divorce

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To be quite honest, this isn't a topic we enjoy discussing with our clients, but divorce is a fact of life and it is important that both parties know and understand the tax ramifications of a divorce during the "negotiations" for lack of a better word. 

Couples who are divorcing have several options for filing taxes.  Neither spouse can file as single until the divorce is final.  A joint return generally offers the lowest tax bracket, but each spouse is then liable for the other's tax liability.  The "innocent spouse" provisions of tax law offer some protection to spouses who don't know about certain income, and some relief from the responsibility for the other's taxes.  

One way to avoid responsibility for the spouse's tax liability is to choose the married filing separately status.  However, tax rates are higher, several potential credits will be lost, and if one spouse itemizes, both must.

Couples who have children and don't live together in the last 6 months of the tax year have another option.  The spouse who pays the majority of household costs for a home that is also the child's home for more than half the year can file as "head of household" (HOH).  

HOH offers several additional credits over married filing separately and it lowers certain marginal tax rates.  The HOH filer can take the standard deduction, which is higher than for married filing separately, even if the other spouse itemizes.  The custodian parent is always entitled to the dependency exemption for each child unless that parent specifically waives the right.

Child Support And Alimony

Divorcing couples who wish to reduce their tax liabilities should consider reclassifying child support payments as alimony.  Child support is excluded from the recipient's taxable income, and the payer cannot deduct it.  Conversely, alimony is included in the recipient's taxable income and the payer can deduct it.

If the alimony or support payer is in a higher tax bracket than the recipient, the money paid as child support will mean more taxes due than if paid as alimony.  The payer may actually be able to make larger alimony payments and save both parties money.  Special rules apply in determining the alimony deduction.

Other Issues

Since the basis of property transferred in a divorce proceeding carries over from one spouse to the other, it's important to consider not only the value of property received but also its tax basis.  The recipient of appreciated property must pay tax on its inherent appreciation when its later sold.  The presence of this future liability should be recognized, quantified and properly reflected in the divorce settlement.

Retirement funds, such as IRAs, 401(k) plans and Keoghs are subject to division of property during divorce.  However, withdrawing the funds early can bring penalties unless a Qualified Domestic Relations Order (QDRO) is obtained.  

The QDRO directs a plan's administrator to pay a specific amount to a child or former spouse.  This amount can be rolled over into a new IRA and is exempt from the early withdrawal penalty even if disbursed directly to the recipient.

 

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