Tax Basics for Divorce

Divorce has a tremendous impact on your finances for years to come — and taxes can significantly impact those finances.  You don’t have to prepare for the CPA exam, but it is important to understand tax basics to make informed decisions that move you toward the life you want to live post-divorce.

Read on for answers to the top divorce tax questions.

What is my Tax Filing Status?

Your marital status sets your federal income tax filing status on the last day of the tax year.

So, if you are still married on December 31, you are considered married for the entire year.  Likewise, if you are divorced on December 31, you are considered divorced for the whole year.

That part is relatively easy.

Here’s where it gets more complicated:

• If you are legally separated, determining your status is more nuanced.
• If you are wondering whether to file head of household or single.

You’ll want to talk to us and your accountant in both cases.

How Do Tax Brackets Work?

When people kick around and say things like, “I make $100,000 and am in the 24% tax bracket,” what does it mean?  Do they pay 24% or $24,000 in tax on their $100,000 income?

Nope.

Here’s an example from 2020 to illustrate why:

We use marginal tax brackets in the United States.  So, generally speaking, whether a person had a taxable income of $9,875, $98,750, or $987,500, in 2020, they all paid a 10% tax on their first $9,875 of income.

(If you are wondering the Alternative Minimum Tax works with all of this, that’s another one that your divorce attorney will work through with you and your accountant.)

Am I Allowed to Claim a Tax Exemption for My Children Post-Divorce?

The general rule is that the custodial parent is entitled to the exemption for children.

But what about families with a shared parenting plan?  Well, that’s when creative lawyering comes into play.  Sometimes, one parent claims one child, and the other claims another.  Sometimes, parents trade years.  In addition, the value of the exemption for children varies significantly depending on income, so sometimes, the exemption is more valuable to one parent than the other.

Is Alimony Taxable?

For years — decades — alimony payments were tax-deductible to the person paying alimony and taxable income to the person receiving alimony.  Under the 2017 tax law, alimony payments are no longer tax-deductible for the payer and aren’t considered taxable income for the recipient.

If you were divorced before 2019, alimony payments are probably still deductible to the payor and income to the recipient.

If you were divorced after December 31, 2018, you probably cannot deduct the alimony payments you make and do not need to pay income tax on the alimony you receive.

As with so many things, there are exceptions — particularly regarding post-judgment.

Do I Have to Pay Tax on Retirement Accounts Divided in Divorce?

Divorce courts have the authority to divide property, including retirement accounts.  And there are ways to avoid taxes (and penalties).

What if I Want to Withdraw Money Transferred to Me Via QDRO?

Many people believe – mistakenly — that taking distributions from retirement assets before age 59 always results in a 10% penalty tax.

But the tax code also provides that money transferred under a QDRO can go directly to the recipient spouse without being subject to the 10% penalty tax.  Note that this only avoids the 10% penalty tax for early withdrawal.  The money withdrawn is taxable in the year it is withdrawn, and there is no way around that.

Can I Withdraw Retirement Funds for Attorneys’ Fees?

We now know you can separate retirement accounts without triggering a taxable event.  We also know you can access that money to spend without paying the 10% penalty regardless of age.

But what if you want to access retirement funds during the divorce to pay your divorce attorney’s fees and do not want to pay the 10% penalty?  Although you can’t withdraw funds during a divorce and avoid the 10% penalty like you can as part of the property division in a divorce, there are two alternatives to consider.  They are a 401k loan and a Roth IRA contribution withdrawal.

Next Steps

As with all issues in divorce, when it comes to taxes, we need to know your goals.  Once we understand what matters most to you, we design a legal strategy to move you toward it.

Our first step at Freed Marcroft, the Goals & Planning Conference, is designed to get to the heart of your problem and unveil your actual goals.  Then, we take those goals along with the facts of your case and analyze them to present you with recommendations and options for moving forward.