How to Handle Taxes During and After Divorce

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Divorce brings about significant changes in many areas of life, and taxes are no exception. The process of untangling shared finances and adjusting to new financial realities can have profound tax implications. Understanding how to handle taxes during and after divorce is crucial to avoiding costly mistakes, minimizing your tax burden, and ensuring compliance with tax laws.

The tax implications of divorce can be complex, affecting everything from your filing status and deductions to how you handle alimony, child support, and the division of assets. It’s essential to be aware of these issues and take proactive steps to manage them effectively. Below are ten key strategies to help you handle taxes during and after divorce.

1. Understand Your Filing Status

Your filing status for the year of your divorce is determined by your marital status on the last day of the year. If your divorce is finalized by December 31, you cannot file as “married” for that tax year.
You will likely need to choose between “single” or “head of household” as your filing status. Head of household status may offer tax benefits, such as a higher standard deduction, but it comes with specific requirements, such as providing more than half the cost of maintaining a home for a dependent.
If your divorce is not finalized by the end of the year, you can still file jointly with your spouse, or you may choose to file separately. Filing separately can protect you from being liable for your spouse’s tax issues, but it may result in a higher tax rate and loss of certain deductions.
Deciding on the best filing status depends on your individual circumstances, and consulting with a tax professional can help you determine the most beneficial option.

2. Address Alimony and Child Support Payments

Alimony (spousal support) and child support payments have different tax implications. For divorces finalized before January 1, 2019, alimony payments are tax-deductible for the payer and taxable income for the recipient. However, for divorces finalized after this date, alimony payments are neither deductible by the payer nor taxable to the recipient.
Child support payments are not deductible by the payer and are not considered taxable income for the recipient, regardless of when the divorce was finalized.
Clearly distinguishing between alimony and child support in your divorce agreement is crucial, as misclassifying payments can lead to tax complications.
If you are receiving alimony, consider how it affects your overall taxable income and plan accordingly to avoid underpayment penalties.
Working with a tax advisor can help you understand the specific tax implications of alimony and child support in your situation and ensure proper reporting.

3. Manage the Division of Assets and Property

The division of assets during divorce can have significant tax consequences. Transfers of property between spouses as part of a divorce settlement are generally tax-free under the IRS rules, as long as they occur before the divorce is finalized or within a specified time afterward.
Capital gains taxes may apply if you later sell assets you received in the divorce, such as real estate or investments. The cost basis of the asset (its original purchase price) transfers with it, which can impact the amount of capital gains tax owed when you sell it.
If you are awarded the family home, be aware of the capital gains exclusion on the sale of a primary residence. You can exclude up to $250,000 ($500,000 if filing jointly) of capital gains if you meet certain criteria. If you sell the home after the divorce, your exclusion may be limited if you don’t meet the ownership and use tests.
Dividing retirement accounts often requires a Qualified Domestic Relations Order (QDRO) to avoid taxes and penalties. Ensure that this order is properly executed to protect your financial interests.
Consider the long-term tax implications of asset division and work with a tax advisor to structure the settlement in a way that minimizes tax liability.

4. Handle Tax Deductions and Credits

The allocation of tax deductions and credits can be a contentious issue during divorce. Common deductions and credits affected include those for dependents, mortgage interest, and education expenses.
Only one parent can claim the dependent exemption (for tax years before 2018) or the Child Tax Credit for each child. Typically, the custodial parent (the parent with whom the child lives for the majority of the year) claims these benefits, but parents can agree to alternate years or otherwise split these tax benefits.
The custodial parent is usually eligible to claim the Earned Income Tax Credit (EITC), the Child and Dependent Care Credit, and the education credits, unless agreed otherwise in the divorce settlement.
If you are paying mortgage interest on a jointly owned home, be sure to determine who will claim the mortgage interest deduction. Only the spouse responsible for paying the mortgage can claim the deduction, even if both names are on the loan.
Make sure that all agreements regarding deductions and credits are clearly outlined in the divorce settlement to avoid future disputes.

5. Address Tax Liabilities and Refunds

If you and your spouse owe taxes from prior years, the responsibility for these liabilities needs to be addressed in the divorce settlement. Both spouses are generally liable for tax debts from joint returns, even after divorce, unless otherwise agreed.
Consider filing an “Innocent Spouse” claim if you believe you should not be held liable for your ex-spouse’s tax debts due to inaccurate or omitted information on a joint return.
If you expect a tax refund for the year in which you file jointly, decide in advance how the refund will be divided. This agreement should be documented in the divorce settlement to avoid future conflicts.
If you’re worried that your spouse may underreport income or claim false deductions on joint returns filed before your divorce, consider filing separately to protect yourself from liability.
Working with a tax professional can help you navigate these issues and ensure that tax liabilities and refunds are handled fairly.

6. Consider Health Insurance and Medical Expenses

Health insurance coverage can be significantly impacted by divorce, particularly if you were covered under your spouse’s employer-sponsored plan. The loss of coverage can have tax implications if you need to purchase a new plan.
COBRA allows you to continue coverage under your spouse’s plan for up to 36 months, but the premiums are often higher than what you were previously paying. These premiums are not tax-deductible unless you qualify to itemize deductions and your medical expenses exceed 7.5% of your adjusted gross income.
If you pay for your child’s medical expenses, you may be eligible to deduct these costs, depending on your filing status and income level. Ensure that these expenses are documented and reported accurately.
Consider the tax implications of any Health Savings Accounts (HSAs) or Flexible Spending Accounts (FSAs) held jointly with your spouse. Contributions, withdrawals, and ownership of these accounts should be addressed in the divorce settlement.
Working with a financial advisor can help you evaluate your health insurance options and plan for the tax impact of medical expenses post-divorce.

7. Plan for Future Tax Implications of Retirement Accounts

Dividing retirement accounts during divorce requires careful planning to avoid tax penalties and ensure that each spouse receives their fair share. A QDRO is typically needed to divide qualified retirement plans, such as 401(k)s, without incurring taxes or early withdrawal penalties.
When dividing IRAs, the transfer must be done correctly to avoid taxes. The division should be specified in the divorce decree, and the funds should be transferred directly between accounts to avoid triggering a taxable event.
Consider how the division of retirement accounts will impact your future tax liability, especially when you begin taking distributions. Taxes on withdrawals will depend on the type of account (e.g., traditional vs. Roth) and your tax bracket at the time of withdrawal.
If you receive a portion of your spouse’s retirement account, consider rolling it over into your own IRA to maintain control and manage the tax implications more effectively.
Work with a tax advisor to understand the long-term tax implications of your retirement accounts post-divorce and to plan for tax-efficient withdrawals in retirement.

8. Navigate the Sale of Marital Property

Selling marital property, such as the family home, can have significant tax implications. Capital gains taxes may apply, depending on the profit from the sale and how the property is titled.
If you sell the home as part of the divorce, you may be eligible for the capital gains exclusion on the first $250,000 of profit ($500,000 if filing jointly), provided you meet the ownership and use requirements.
If you decide to keep the home and sell it later, your eligibility for the exclusion may change, particularly if you remarry or move out of the home before the sale.
Consider how the proceeds from the sale of marital property will be divided and how this division will impact your tax liability. Ensure that these details are clearly outlined in the divorce settlement.
Consulting with a tax professional can help you plan for the tax consequences of selling marital property and optimize your strategy for minimizing capital gains taxes.

9. Protect Your Credit and Financial Standing

Divorce can impact your credit, especially if joint debts are not managed properly. Ensure that all joint accounts are closed or converted to individual accounts to prevent future liabilities.
Consider how tax debts, if any, will be paid and who will be responsible for them. Unpaid tax liabilities can damage your credit and lead to legal complications.
Monitor your credit report regularly during and after the divorce to identify any issues, such as unauthorized charges or missed payments, that could affect your credit score.
Take steps to protect your financial standing by staying on top of tax payments, resolving any outstanding tax issues promptly, and maintaining good credit habits.
Working with a financial advisor or credit counselor can help you navigate these challenges and maintain financial stability during and after the divorce.

10. Seek Professional Tax Advice

The tax implications of divorce are complex, and seeking professional advice is often the best way to ensure that you handle taxes correctly and avoid costly mistakes.
A tax advisor or Certified Divorce Financial Analyst (CDFA) can help you understand the tax consequences of your divorce settlement, plan for future tax obligations, and optimize your financial strategy.
Consider working with a divorce attorney who understands the tax implications of divorce and can ensure that your settlement is structured in a tax-efficient manner.
If you are concerned about the potential for future tax issues, such as audits or disputes with your ex-spouse, consulting with a tax attorney may provide additional protection.
Professional tax advice provides the expertise and guidance you need to navigate the complexities of divorce and ensure that your tax obligations are managed effectively.

Conclusion

Handling taxes during and after divorce requires careful planning and a thorough understanding of the tax implications of your settlement. From choosing the right filing status to managing the division of assets and addressing future tax liabilities, each step is crucial to protecting your financial future. By taking a proactive approach and seeking professional advice, you can minimize your tax burden, avoid common pitfalls, and ensure that your tax obligations are met.

Divorce is challenging, but with the right strategies in place, you can navigate the tax complexities and move forward with confidence. By understanding the tax implications and making informed decisions, you can secure your financial stability and focus on building a new future.