Divorce and separation are life-changing events that can significantly impact your financial situation, including your taxes. Understanding how marital status changes affect tax filings can help you navigate this challenging time and make informed decisions that align with your financial goals. Here’s a comprehensive look at how divorce and separation can influence various aspects of your taxes, from filing status to alimony and dependents.
- Understanding Your Filing Status
The first tax consideration after a divorce or separation is determining your filing status. Filing status impacts your tax rates, eligibility for certain credits, and the standard deduction amount.
- Marital Status on December 31: For tax purposes, your marital status as of December 31 determines your filing status for the entire year. If your divorce is finalized by that date, you’ll file as “single” or “head of household” if you meet certain criteria. If you’re still legally married on December 31, you can either file as “married filing jointly” or “married filing separately.”
- Head of Household: To qualify as “head of household,” you must pay more than half the cost of maintaining a home and have a qualifying dependent, such as a child, living with you for more than half the year. This filing status offers lower tax rates and a higher standard deduction than “single” or “married filing separately,” making it a valuable option if you’re eligible.
- Taxable and Non-Taxable Alimony
Alimony payments are another area where tax implications have changed significantly in recent years. Understanding these changes can help both payers and recipients better plan for their tax obligations.
- Tax Cuts and Jobs Act (TCJA) Changes: Prior to the TCJA, alimony payments were deductible by the payer and included as income by the recipient. For divorce or separation agreements executed after December 31, 2018, alimony is no longer deductible for the payer, nor is it considered taxable income for the recipient. This change has had a notable impact on divorce negotiations, as alimony payments no longer provide the same tax advantages they once did.
- Modifying Pre-2019 Agreements: For alimony agreements established before 2019, the original tax treatment still applies unless the agreement is modified, and both parties agree to follow the new tax rules.
- Child Support Payments
Child support payments, unlike alimony, are not deductible by the payer and are not considered taxable income for the recipient. This tax-neutral status applies regardless of when the divorce or separation occurred. Since child support doesn’t impact your taxes directly, it’s essential to plan accordingly for these expenses.
- Who Claims the Dependents?
Determining which parent claims a child as a dependent can be a major point of contention in divorce and separation agreements, as it directly affects tax benefits and credits. Generally, only one parent can claim each dependent on their tax return in a given year.
- Custodial vs. Non-Custodial Parent: The custodial parent—typically the one with whom the child spends the most nights during the year—is usually the one entitled to claim the child as a dependent. However, the custodial parent can sign a release allowing the non-custodial parent to claim the child.
- Tax Credits and Exemptions: Claiming a child as a dependent can entitle the taxpayer to valuable tax benefits, such as the Child Tax Credit and the Earned Income Tax Credit. Some credits, like the Child and Dependent Care Credit, can only be claimed by the custodial parent, even if the dependency claim is released to the non-custodial parent.
- Division of Property and Capital Gains
Dividing assets during a divorce or separation can have significant tax consequences, particularly when it comes to property like a home or investments. Properly understanding these implications can prevent unexpected tax burdens.
- Primary Residence: When a jointly owned primary residence is sold, each spouse can typically exclude up to $250,000 of capital gains from the sale, provided they meet certain criteria. However, if one spouse buys out the other’s interest, the selling spouse may be subject to capital gains taxes on their portion of the sale.
- Retirement Accounts: Transferring retirement accounts, like IRAs or 401(k)s, as part of a divorce settlement can result in taxes and penalties if not done correctly. A Qualified Domestic Relations Order (QDRO) is often used to transfer retirement funds without triggering tax penalties. Without a QDRO, early distributions may be subject to taxes and a 10% penalty if taken before age 59½.
- Health Insurance and Medical Expenses
Divorce or separation can also affect health insurance coverage and the deductibility of medical expenses, so it’s essential to plan accordingly.
- Health Insurance: Spouses who were covered under a partner’s employer-sponsored health plan may lose that coverage after a divorce. Many qualify for COBRA continuation coverage, but it can be costly. It’s wise to consider alternative insurance options, including those offered through the Health Insurance Marketplace.
- Medical Expenses Deduction: If you pay medical expenses for a child or former spouse, these may be deductible, provided they meet certain thresholds. The IRS allows you to deduct unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI) if you itemize deductions.
- Legal Fees and Divorce-Related Expenses
Unfortunately, most divorce-related expenses, including attorney fees, are not tax-deductible. However, there are a few exceptions worth noting.
- Deductible Fees: Legal fees related to obtaining alimony may be deductible for divorces finalized before 2019. In these cases, you may be able to deduct the portion of legal fees spent on securing alimony as an income-producing expense.
- Changing Your Tax Withholding and Planning for the Future
A change in marital status is an ideal time to reassess your tax withholding and make any necessary adjustments. If your income or filing status changes, consider adjusting your W-4 with your employer to avoid unexpected tax bills or penalties at year-end.
- Estimated Taxes: If you’re receiving alimony or expect to pay significant capital gains taxes, it may be necessary to make estimated tax payments. Estimated payments are typically due quarterly and can prevent a large tax bill when you file your annual return.
- Consult a Tax Professional: Tax laws surrounding divorce and separation can be complex and are subject to frequent changes. Consulting a CPA or tax professional can help you navigate these challenges and ensure that you’re maximizing any tax benefits available.
Let’s Wrap It Up!
Divorce and separation bring many financial changes, including significant tax implications. From determining your filing status to understanding the treatment of alimony and dependents, these tax considerations can impact your overall financial well-being. With careful planning and professional guidance, you can manage these changes and create a more secure financial future. Remember that each situation is unique, so it’s important to evaluate your options and make the choices that best align with your circumstances.
