Are you going through a divorce? You probably have a lot on your plate. You may have to plan for finding a new residence, working out a custodial agreement for your kids, and even establishing your own financial independence. On top of that, you're also likely dealing with intense emotions and a lot of personal stress.
During this period, it's easy to forget about taxes. However, tax planning during divorce is a very important step. Ignore tax planning and you may find yourself with an unnecessarily large bill. Tax planning during divorce can also help you hammer out some of the larger components of your divorce agreements. A full understanding of your new tax situation will allow you to negotiate your agreement with confidence and to make fully informed decisions.
Here are a few of the most common questions with regard to tax planning during divorce:
1) What's my filing status?
Your filing status is whatever your legal situation was on the last day of the year. If you were married, you file as married. If you were legally divorced, you can file as single or head of household.
If you were married, you can choose between filing joint or individually. Filing a joint return may have some tax benefits. However, it also comes with a very big caveat. The IRS holds both spouses responsible for any mistakes or errors made on a return. Even if the error is your ex-spouse's fault, you can still be held responsible. Is a more favorable tax outcome worth the risk being legally and financially tied to your ex-spouse's actions?
If you were single on December 31, you can choose between filing as a single person or as head of household. If you don't have kids, the choice is easy - you're single. However, if you have kids and you are the custodial parent, you can file as head of household and get additional deductions for your children.
2) Who claims the kids?
The IRS allows for generous exemptions for children, so there's incentive for each parent to claim them. However, only one of you can. The custodial parent always has the ability to claim exemptions for the kids. It is possible for the custodial parent to transfer the exemptions to the other parent, although that's something that would need to be negotiated.
Similarly, any child care deductions also go to the custodial parent. Unlike exemptions, these deductions can't be transferred.
3) What's the tax status of alimony and child support?
This is possibly the most common question asked with regard to tax planning during divorce. Alimony is taxable for the receiving spouse and deductible for the paying spouse. Child support is not taxable and is not deductible.
Given the tax treatment of alimony, there is incentive for the paying spouse to classify as much of the support obligations as possible as alimony. Common tricks are to classify child support as alimony or to structure the settlement of assets as alimony. Doing so allows the payer to take a larger deduction.
The IRS takes a skeptical view of these tactics. For example, if a portion of the alimony is scheduled to end when a child becomes 18, the IRS is likely to say it's child support and not alimony. Similarly, if there is a large one-time payment of alimony right after the divorce, the IRS will say it's the settlement of assets and not alimony. It's better to be clear and transparent with support payments and avoid these types of tactice.
4) We're splitting retirement assets. Are those distributions taxable?
Not if they're processed the correct way. If you're receiving a portion of your ex-spouse's retirement assets, you should receive a document called a Qualified Domestic Relations Order, also known as a QDRO.
A QDRO is a document that you can present to your ex-spouse's retirement account custodians so they will distribute the assets correctly. Now, the taxability of the assets depends on what you do with them. If you roll them into your own qualified retirement account, like an IRA, there won't be any tax liability. If you cash out the proceeds, then you'll have to pay income tax, but you won't have to pay the penalty for an early retirement distribution.
Retirement assets are often substantial amounts. There's often some urgency among spouses to collect on the assets because they need money to pay bills. Always wait until the QDRO has been issued before initiating the distribution. If the distribution is started without a QDRO, you could have to pay a 10 percent early withdrawal penalty in addition to any taxes.
5) What about my ex-spouse's tax mistakes?
Financial troubles often factor into many divorces. When financial troubles are present, tax problems are very often also associated. If your ex-spouse either accidentally or knowingly made errors on your joint tax return, the IRS will initially hold you jointly responsible for the penalties.
The IRS does offer something called an "innocent spouse rule." The rule waives you of all responsibility for your spouse's errors. In order to qualify, you must show that the spouse's errors only applied to his or her income or deductions, that you had no way of knowing about the errors, and that it would be unfair to hold you financially responsible.
Proving innocence under this rule is possible, but it can be extremely complicated. If you are going to pursue this route, it's wise to get advice from an accountant, tax attorney, or another trusted professional.
6) Can I deduct my divorce costs?
Generally, no, you cannot. The IRS views divorce as a personal expense, so they don't allow for it as a deduction. However, you may be able to deduct a portion of your legal fees if they included tax advice. Tax preparation and advice is deductible. Just another reason to discuss tax planning during divorce with your attorney or tax professional.
Divorce is a stressful and complicated process. However, don't let your taxes get lost in the shuffle. Tax planning during divorce is an important process to ensure that you don't get hit with excessive penalties and tax liabilities.
