This blog post is from David Droppo, a collaboratively trained financial advisor with Ameriprise Financial in Dallas, Texas. He is a Certified Divorce Financial Analyst™and a Certified Financial Planner™.
This is the one week out of the year in which, for many of us, taxes loom largest. For couples in the divorce process, tax issues can be particularly tricky, and it’s good to know what to do while you’re getting divorced and once you’re officially single again. You should understand the tax impact of filing status, how household income and expenses can be divided for tax purposes, and how decisions you make now may affect you down the line. It’s also important for those getting divorced to know the tax treatment of pensions, child support, alimony, property division and the significance of dependency exemptions.
The importance of filing status
Filing status is key because it establishes which tax rates apply and the amount of tax owed. It also determines, in part, the number of standard deductions and credits available. Knowing which filing statuses are available will help determine which one will best fit a situation. You can file as:
• Married filing jointly
• Married filing separately
• Head of household, or
• Qualifying widow(er) with dependent child
Whether you are considered married or single for tax reasons is not always obvious. In general, filing status is determined by legal status on the last day of the year. If you are single on December 31, then for tax purposes, you may be considered single for the entire year. In order to minimize income tax liability, it may be advantageous to plan the timing of your filing status. If more than one filing status applies; choose the one that gives the lowest amount of taxes.
During a divorce, spouses may wish to continue filing jointly for as long as possible. While filing jointly enjoys advantages over other filing statuses — taxes may be lower, standard deductions may be higher, and other tax benefits may apply – also be aware that there can be disadvantages. Much the same way as you have rights to a tax refund, the other spouse’s debts and liabilities will be attached to the taxes. For example, a joint return may obligate both spouses to be jointly and severally liable for any error on the tax return.
Dividing income and deductions
Along with dividing assets and debts during divorce, tax-related issues concerning income and deductions should be resolved. Jointly held assets can create income in the form of dividends and interest. In addition, there are deductions from real estate taxes, mortgage interest, medical cost deductions, and loss carry-forwards to be allocated.
Taxation of pensions and alimony
Like other property that can be divided (house, cars, bank accounts), a retirement plan is a form of property. If either spouse has a retirement plan then you should understand what a qualified domestic relations order (QDRO) is, and whether it applies to your retirement plan. Also know the tax ramifications when retirement plans are divided after the divorce.
Alimony is a payment made to a former spouse pursuant to a divorce decree to help maintain his/her lifestyle. Payments are deductible by the payer and included in the recipient’s income. To be considered alimony for tax purposes, it must meet certain requirements; IRS Publication 504 is a helpful resource for this. Child support is viewed differently in that payments are not deductible by the payer, and are received tax-free by the recipient.
Dependency exemptions and child tax credits
Another important tax decision involves the assignment of dependency exemptions. You should understand the custodian parent’s rights to these exemptions, the choice to transfer to the non-custodian parent, and the requirements needed to claim a dependency exemption.
Custodian parents may be granted a child tax credit for each dependent child. There is also a child-care expense credit to qualifying parents. As with dependency exemptions, the custodian parent may elect to transfer these rights to the non-custodian parent. This may be done to provide a greater tax savings for the lower income parent.
When spouses decide how to split their property, there are several decisions to be made that impact taxes. Likely a property settlement agreement is drawn up, assets and debts are assigned to one spouse or the other, and other assets may be sold and the proceeds divided. The tax effects of property division vary greatly depending on whether you decided to transfer to a spouse, sell the property, and the timing of each decision.
Generally speaking, there is no gain or loss recognized for property transferred to a spouse or former spouse, pursuant to a divorce. If the transfer occurs incident to the divorce and within one year or the marriage ending, it may be considered a gift.
A common consideration is selling what is often the largest asset, the marital home. If certain requirements are met the Internal Revenue Code allows that up to $500,000 of gains can be excluded from the sale if both spouses file jointly. The exclusion is reduced to $250,000 for single filers. Therefore, if a large gain exists, then selling while still married provides a greater tax savings.
Dividing rights to property accumulated over a lifetime is not without difficulty. An advantage of using the collaborative process having a skilled team that can overcome impediments and create a best-fit solution that maximizes tax savings for both spouses.