Getting divorced has tax implications as well as financial ones. In this article we’ll explore some of the common tax implications of divorce and address some things that can also get commonly overlooked. If you have a complicated tax situation, are filing for high net worth divorce, or are dividing a business with your former spouse, the tax implications of your divorce may fall outside of the scope of this article.
The collaborative divorce attorneys in the state of Washington and Seattle at Truce Law help couples navigate the many challenges that can arise during divorce, including addressing some of the common tax questions that couples have. One of the benefits of collaborative divorce is that couples can choose which professionals they bring to the negotiating table. In some situations, couples consult tax professionals alongside their collaborative attorneys to address some of the more complicated tax questions that can arise with divorce.
In this article we’ll explore:
- How Divorce Can Affect Your Filing Status
- How Divorce Can Affect Your Tax Withholding
- How Divorce Can Affect Your Child Tax Credit
- Divorce and Your IRA
- Ongoing Tax Liabilities After You Divorce
- Tax Loss Carryforwards and Your Divorce
- Less Common Tax Issues and Your Divorce
How Divorce Can Affect Your Filing Status
Your marital status at the end of the year determines your tax filing status. If your divorce wasn’t finalized by the end of last year, then you would generally be considered married for tax filing purposes. If your legal separation was finalized before the end of last year, you’ll file as single.
Couples who are considered married for tax purposes can choose to file as “married, filing separately” but because the state of Washington is a community property state, the IRS has specific rules for married couples who choose to file separately.
In general, couples who are married pay less in taxes if they file jointly than if they choose to file separately, but you’d need to ultimately consult with your tax professional to determine what’s best for your given situation. If you choose to file your tax return separately from your spouse, you are legally required to report half of all community income, and all your separate income.
Determining community and separate property isn’t always straightforward, and in some cases, couples choose to consult a divorce lawyer to help them sort through their situation.
In general, community income is income derived from community property, from salaries and wages earned while living in a community property state, and income from real estate that is considered community property under the laws of the state. Community property is any property purchased or acquired during your marriage (though there are some exceptions, such as with an inheritance or in the case of property purchased using separate funds earned before the marriage).
Separate income would be income that is earned from separate property or real estate, or money earned while you were working or living in a non-community property state.
Things can get complicated, though. A divorce lawyer can help you work out which property and income would be considered separate and which property is considered community property under Washington law or under the terms of a prenuptial agreement, if you have one.
Because the timing of your divorce can impact your tax obligations, some couples choose to time their divorce to receive the maximum possible benefit. For example, couples who are married and filing jointly, may be able to share mortgage interest deductions and property tax deductions. With collaborative divorce, you get more control over the timing and settlement process. Your collaborative divorce lawyer in the state of Washington at Truce Law, along with your tax professionals, can help you find a path to divorce that’s best for you and your partner.
How Divorce Can Affect Your Tax Withholding
When you get divorced or legally separated, you’ll need to adjust the tax withheld from your paycheck. You can use the IRS’s tax withholding estimator and then submit the results to your employer so that they can give you a new W-4 to fill out. That said, individuals with complex tax situations might need to consult with a tax professional and may not want to use the IRS’s tax withholding estimator to estimate their tax obligations.
Laws passed after 2018 affect how alimony is taxed. For couples getting divorced after 2019, the spouse paying alimony isn’t allowed to deduct alimony payments, and the spouse receiving alimony doesn’t count received alimony as income. If you’re getting divorced this year, alimony shouldn’t affect your tax withholding or how much you owe.
How Divorce Can Affect Your Child Tax Credit
One of the big questions that can arise with divorce when you have children is which parent will claim the children as dependents for tax purposes. In most situations, the parent with custody of the children more nights of the tax year can claim the child tax credit and can claim the child as a dependent. Yet, there are certain exceptions to this rule.
If one parent contributes more than 50% financially to support the child, that parent might be entitled to take the child tax credit, even if the child spends less time with them during the year. In this case, the custodial parent must sign a form declaring that they won’t be claiming their child as a dependent.
Yet things can get complicated if you and your partner decide on a 50-50% custody split. Because more couples are choosing this custody arrangement, the tax implications must be discussed. For the purposes of the Federal child tax credit, the federal government doesn’t recognize shared custody. You can’t split the child tax credit in half. Only one parent can take the tax credit.
In any 50-50 custody split, one parent will have 183 overnights, and one parent will have 182 overnights. For the purposes of Federal law, the parent with 183 overnights is the custodial parent entitled to take the child tax credit.
The problem with this is that few 50-50 custody arrangements are so surgically precise. One parent might have the children for more overnights one year and fewer overnights another year. In the case of an emergency, vacation, or other situation, the agreed upon custody schedule might be adjusted. This also doesn’t consider normal variations that will occur in the custody plan due to split holidays.
Most parents who agree to a 50-50 custody split, either agree contractually to alternate years each parent will take the child tax credit and claim the child as a dependent or decide ahead of time who will claim the tax credit.
Yet, different situations might warrant more creative solutions. If the parents have two children, or an even number of children, one parent will take the child tax credit for one child, while the other parent will take the child tax credit for the second child.
Other parents might use the child tax credit as a negotiation tool in their divorce settlement process. If one parent agrees to give the other parent the child tax credit benefit, then he or she might have room to negotiate other benefits he or she wants in the divorce (for example reduced alimony payments equal to the tax benefit).
In some situations, one parent may not qualify for the child tax credit because he or she earns too much money or doesn’t qualify for the tax credit for other reasons. In this situation, the other parent may be able to take the child tax credit themselves.
The child tax credit can also have additional value if you are a parent who sends your child to day care or if you need to pay for childcare so that you can go to work. If you send your child to day care, preschool, after school care (or before school care), or a day camp so that you can work, and are the custodial parent for tax purposes, you may also be able to claim the child and dependent care credit, which can reduce your tax obligations worth up to 35% of up to $3000 worth of day care expenses. The custodial parent generally can take this tax credit.
Custodial parents also can file for head of household status if you are single or legally separated, have paid more than half the cost of maintaining your household, and can claim one or more dependents. Head of household status gives you access to a larger standard deduction than the standard deduction for single filers. Additionally, if you are the custodial parent, and earn under a certain income threshold, you may also qualify for the earned income tax credit.
Because being named the custodial parent can carry some significant tax benefits for this parent, this is something that should be carefully discussed and considered when negotiating your divorce settlement. The Washington state collaborative divorce attorneys at Truce Law help couples negotiate divorce settlements that work for them.
If your situation is complicated, the collaborative divorce process lets you bring tax professionals and other experts to the negotiating table. Unlike taking your divorce to court where your future lies in the hands of a judge, the collaborative divorce process allows you and your partner to decide about custody, and the tax implications of custody in private.
The collaborative divorce process can give you and your partner freedom to find creative solutions that a judge might not be able to make.
Divorce and Your IRA
Normally, when you withdraw money from an IRA, you’ll face a hefty tax bill. The one exception to this is when a couple gets divorced and needs to split an IRA or retirement plan. The IRS will allow one spouse to withdraw money from an IRA or retirement plan without penalty if they have a qualified domestic relations order (QDRO) in place. It’s important to keep in mind that unless the spouse withdrawing funds places the funds in a new IRA, the money withdrawn might be considered income and subject to taxation.
Divorce can also impact the deductions you may be permitted to take for the tax year you get divorced. If you contributed money to your spouse’s IRA and get divorced, federal law doesn’t permit you to deduct contributions you made to your former spouse’s IRA.
Finally, one spouse can transfer money to another spouse’s IRA tax-free. Yet, the spouse who receives this money should keep in mind that when this money is withdrawn, it will be subject to taxation.
Couples who are working out a divorce settlement would need to keep in mind that dollar-for-dollar, money transferred from one IRA to another would generally be worth less money than dollar-for-dollar amounts transferred between savings accounts that include income that has already been subject to income tax.
There have been situations where one spouse agrees to what seems like a generous IRA to IRA transfer, foregoing the split of a savings account or split of other assets, only to later realize that the after-tax value of this account is less than if they had split a bank account or other asset. Your divorce lawyer, along with your tax professionals, can look over your divorce settlement before you finalize it to catch any of these issues.
Splitting Assets and Taxes
Some assets need to be sold for you to realize their cash value, and when these assets are sold, you’ll pay taxes on the capital gains. Your Washington state divorce lawyer can review your divorce settlement to make sure you’re not dividing taxable assets without considering the future tax obligations on these assets. In complex situations, your divorce lawyer, along with tax professionals can review your divorce settlement.
Ongoing Tax Liabilities After You Divorce
When filing for divorce, it’s important to ask yourselves if you and your spouse filed tax returns for each year you were married. And if you were married but filed separately, you might want to ask your former partner to bring copies of his or her past tax returns to the negotiating table for review by a tax professional.
Most divorce settlements are made with the assumption that both parties settled their tax obligations for prior years and that any taxes owed were paid during the marriage. Yet, if you get audited by the IRS for the years you were married (even after you are divorced), both parties in the marriage could end up with an outstanding tax bill.
If one of you owns a business, has complex investments, or has a complicated tax situation, you might want to have a tax professional review you and your spouse’s taxes from prior years before finalizing your divorce. You don’t want to finalize your divorce agreement, have one of you get audited by the IRS, and suddenly find yourself facing a tax bill from the IRS for the years you were married.
Tax Loss Carryforwards and Your Divorce
If you or your partner reported a loss on your tax return, you can carryforward this loss to reduce your liability on future tax years where you report gains. A tax loss carryforward could be considered an asset during your divorce negotiation because the carryforward can reduce tax liability in future years. This is a complicated tax situation. Your tax professional can help you understand your options when it comes to this potentially valuable tax benefit before you sit down to negotiate your divorce settlement.
Less Common Tax Issues and Your Divorce
High net worth couples, and couples that pay quarterly payments to the IRS, or spouses who aren’t on W-2s may also have unique tax situations that they bring to the negotiating table during divorce. For example, if your spouse overpays on his or her quarterly tax payments, he or she may be due to receive a refund at the end of the year that might be considered community property.
Couples who might face large capital gains liabilities if they must liquidate assets during a divorce, might want to work out alternative divorce settlement arrangements with their financial advisors and tax professionals to prevent losing wealth through the divorce process. While assets transferred during divorce aren’t considered capital gains, assets that are sold during divorce that have increased in value during the marriage may represent a tax liability for the couple or individual liquidating assets to pay for a divorce settlement.
Next Steps
The divorce lawyers at Truce Law understand that divorce settlements often involve so much more than just splitting assets and moving on. The tax liabilities of certain assets can reduce their cash value to the spouse receiving this asset. Your divorce lawyer can help you address these concerns during your divorce negotiations, or help you bring in tax professionals in to help you work things out.
The tax implications of divorce are not reserved for the wealthy. Couples with children need to consider who will get the child tax credit and other custodial credits. Couples with small businesses and unique tax situations may have more to consider when they sit down to settle their divorce.
During the collaborative divorce process, couples work with their lawyers, and other experts, including tax professionals, to help them find the best possible divorce settlement for their needs. If you have questions about how divorce might impact your taxes or have questions about whether collaborative divorce is right for you, reach out to Truce Law today. Our Seattle, Washington collaborative divorce attorneys are here to help.
This article is for educational purposes only and does not constitute legal advice. Every situation is unique. For guidance specific to your circumstances, consult a licensed family law attorney in your area.