Tax Tips: Understanding the Tax Implications of Your Divorce
Divorce not only changes your personal life but also has significant tax implications. From your filing status to exemptions and deductions, understanding how divorce affects your taxes can help you avoid costly surprises and plan for your financial future. In this blog post, we explore the key tax consequences of divorce and offer tips to help you navigate these changes.
1. Filing Status
One of the most immediate tax changes after divorce is your filing status. Your status as of December 31st determines how you file for that tax year. After a divorce, you’ll typically file as either single or head of household if you meet certain criteria. Discuss with your financial analyst and/or tax advisor what filing status will be most beneficial for you post-divorce.
2. Exemptions and Dependents
Claiming dependents is another area that may change after divorce. Typically, only one parent can claim a child as a dependent on their tax return each year. Consider including provisions in your divorce agreement that clarify who will claim the children each year to avoid confusion and potential disputes. Your financial analyst can help you determine the benefits of either spouse claiming some or all of the children on their tax returns dependent on income and the credits they may qualify to receive.
Custodial Parent: The custodial parent, who the child lives with for the majority of the year, usually has the right to claim the child as a dependent. This comes with tax benefits, including the Child Tax Credit and the Earned Income Tax Credit (EITC).
Non-Custodial Parent: In some cases, the custodial parent can sign a release (Form 8332) allowing the non-custodial parent to claim the child for tax purposes. However, this may not include the EITC or the Head of Household status.
3. Alimony and Child Support
The tax treatment of alimony and child support has changed under recent tax laws. Make sure you understand the tax implications of any spousal support or alimony agreements as you negotiate your divorce settlement.
Alimony: For divorces finalized after December 31, 2018, alimony payments are no longer tax-deductible for the payer, nor are they considered taxable income for the recipient. This change has shifted the financial dynamics of alimony agreements, making it essential to consider tax implications during negotiations. This may also affect a non-wage-earner’s ability to contribute to their own individual retirement plans post-divorce.
Child Support: Child support payments are neither deductible for the payer nor considered taxable income for the recipient. This has always been the case, so the tax impact of child support remains unchanged.
4. Property Division
The division of property in a divorce can also have tax consequences. While the transfer of assets between spouses as part of a divorce settlement is generally tax-free, future taxes on those assets can be significant. Work with a Certified Divorce Financial Analyst (CDFA) or a tax professional to understand the tax implications of any asset you ask for in the divorce so you can plan for potential future liabilities. These issues are commonly missed in the divorce process and can have a significant impact on the equitability of the settlement.
Capital Gains: If you receive property, such as a house or investments, as part of the divorce settlement, you may face capital gains taxes when you sell those assets. The cost basis (original value) of the asset transfers with the property, which means you may owe taxes on the increase in value from the original purchase price when you sell.
Retirement Accounts: Dividing retirement accounts can be complicated. Transferring funds from a retirement account, such as a 401(k) or IRA, requires a Qualified Domestic Relations Order (QDRO) to avoid penalties and taxes. Even with a QDRO, taxes may apply when you withdraw the funds, so it’s important to plan accordingly.
5. Tax Deductions and Credits
Divorce can affect your eligibility for certain tax deductions and credits. Review all deductions and credits you previously claimed with your financial analyst to see how your eligibility may change after divorce.
Mortgage Interest Deduction: If you owned a home with your spouse, selling or transferring the property as part of the divorce may impact your ability to claim the mortgage interest deduction. If you keep the house, you may be able to continue to claim the deduction if you itemize your taxes.
Education Credits: If you or your children are in school, you may lose access to education-related tax credits, such as the American Opportunity Credit or Lifetime Learning Credit, depending on your income and filing status.
As you can see, divorce brings significant changes to your tax situation, from filing status and exemptions to the tax treatment of alimony and property division. Understanding these tax implications can help you avoid surprises and plan for your financial future. Consulting with a Certified Divorce Financial Analyst (CDFA) or tax professional is essential to ensure that you navigate these changes effectively and make informed decisions during the divorce process.
A Certified Divorce Financial Analyst (CDFA) can help make the process easier to understand and enable you to feel confident about your decisions during the financial settlement process. It’s important you know and understand the long-term ramifications of your choices to save you from costly mistakes.
We are here for you so you
don’t have to do it alone.
Contact us to schedule your free consultation.