8 Things to Know About Divorce & Taxes
Going through a divorce can be one of the most challenging experiences in life. It's often a long and arduous process that affects everyone involved. Many aspects of life change post-divorce, and it can feel overwhelming. However, it's important to remember that you will get through this, and you'll emerge stronger. Even when everything seems uncertain, there is hope and a path forward.
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Financial changes are some of the most significant adjustments during a divorce. These can include finding new employment, handling legal fees, or securing alimony or child custody payments. All these financial shifts can make filing your taxes more complex.
Let’s explore the key points you need to understand about filing taxes after a divorce, so you can approach your tax return with confidence.
1. Determine Your Filing Status
Source: IRS
Your filing status determines your filing requirements, standard deduction, eligibility for certain credits, and overall tax obligation. Here's a breakdown to help you understand the implications of your new status:
Filing Status Based on Marital Status at Year-End
Married by Year-End: If you're not legally separated or divorced by December 31, the IRS considers you married for the entire tax year. This means you can choose to file as "Married Filing Jointly" or "Married Filing Separately."
Divorced by Year-End: If your divorce is finalized by December 31, you cannot file as married. Instead, you must file as "Single" or "Head of Household" if you meet the criteria.
Specific Filing Statuses
Married Filing Jointly:
On a joint return, you and your spouse report your combined income and deduct your combined allowable expenses.
This status often results in a lower tax liability due to a higher standard deduction and eligibility for various credits.
In certain cases, you may be relieved from liability for taxes owed on a joint return through tax relief provisions for spouses.
Married Filing Separately:
If you file separate returns, you report only your income, deductions, and credits on your individual return.
The rules differ if you live in a community property state, so it's crucial to check the specific regulations for those states.
Both spouses should carefully consider whether filing jointly or separately is more advantageous for their situation.
Head of Household:
This status provides a higher standard deduction and more favorable tax brackets compared to filing as Single.
To qualify, you must:
Be considered unmarried on the last day of the tax year.
Have a qualifying child or dependent who lived with you for more than half the year.
Pay more than half the cost of keeping up your home.
Your spouse must not have lived in your home for the last six months of the year.
Other Considerations
Separated but Not Legally Divorced:
If you're separated but do not have a final decree of divorce or separate maintenance by December 31, the IRS still considers you married for tax purposes.
Annulled Marriages:
If your marriage is annulled, you must file amended returns for all affected tax years that are still open under the statute of limitations (typically three years from filing the original return or two years from paying the tax, whichever is later).
On amended returns, you must file as Single or, if eligible, Head of Household.
To choose the right filing status for your situation, consider using the Interactive Tax Assistant provided by the IRS.
Importance of Changing Your Filing Status
Changing your filing status from Married to Single or Head of Household can have significant tax implications:
Standard Deduction: Your standard deduction amount changes based on your filing status. For instance, the standard deduction for a Single filer is lower than for a Married Filing Jointly filer. However, the Head of Household deduction is higher than the Single deduction.
Tax Rates and Brackets: Different filing statuses have different tax brackets. Changing your status can move you into a different tax bracket, affecting your overall tax rate.
Eligibility for Credits and Deductions: Certain tax credits and deductions are only available or more advantageous under specific filing statuses. For example, the Earned Income Tax Credit (EITC) and Child and Dependent Care Credit may be more beneficial when filing as Head of Household.
2. Update Your W-4 Form
Source: IRS Employee’s Withholding Certificate
After a divorce, updating your W-4 form is an important step to ensure the correct amount of tax is withheld from your paycheck. Here's what you need to know:
Why Update Your W-4?
Your Form W-4, Employee’s Withholding Certificate, determines how much federal income tax your employer withholds from your paycheck. If you’ve been claiming a personal allowance for your spouse and you divorce or legally separate, you need to give your employer a new Form W-4 within 10 days after the divorce or separation. This adjustment helps ensure that your withholding accurately reflects your new tax situation.
Changes in Withholding
No More Personal Allowances: The Form W-4 no longer uses personal allowances to calculate your income tax withholding. Instead, it focuses on your filing status and the number of dependents you can claim.
Reflecting Your New Status: If you’ve been filing as married and will now be filing as single or head of household, you need to update this information on your W-4 to avoid under-withholding and a large tax bill at the end of the year.
Steps to Update Your W-4
Obtain a New Form W-4: You can download the latest Form W-4 from the IRS website or get one from your employer.
Complete the Form: Follow the instructions on the form to update your filing status, number of dependents, and any additional adjustments you need to make.
Submit to Your Employer: Return the completed W-4 to your employer as soon as possible. They will update your withholding based on the new information.
3. Name and Address Changes
If you change your name, notify the Social Security Administration (SSA) before filing your tax return to avoid processing delays. For address changes, complete and submit IRS Form 8822. Ensuring your information matches IRS records helps streamline the tax filing process.
For more detailed information and resources, visit the IRS website or consult IRS Publication 504, which covers tax rules for divorced or separated individuals
4. Claiming Dependents
Claiming dependents requires careful consideration and often mutual agreement between divorced or separated parents. Understanding who has the right to claim the children and how it affects your tax return can help avoid conflicts and ensure that both parents maximize their potential tax benefits.
Who Can Claim Children as Dependents?
Custodial Parent: This is the parent the child lives with most of the time during the tax year. Usually, the divorce agreement will specify who the custodial parent is. If you are the custodial parent, you get to claim your children as dependents on your tax return. This can qualify you for:
Earned Income Tax Credit (EITC): A benefit for working people with low to moderate income, which can reduce the amount of tax owed.
Child and Dependent Care Credit: This helps offset costs for daycare or childcare services needed so you can work or look for work.
Who Can’t Claim Children as Dependents?
Noncustodial Parent: If your children live with you less than they do with your ex, you’re the noncustodial parent. Generally, you can't claim your children as dependents. This means you also miss out on:
Head of Household Filing Status
Earned Income Tax Credit (EITC)
Child and Dependent Care Credit
The One Exception
There’s a special rule for noncustodial parents. You can claim a child as a dependent if the custodial parent signs IRS Form 8332, "Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent." Here’s the process:
The custodial parent fills out and signs Form 8332 for each child.
You, as the noncustodial parent, attach these forms to your tax return each year you claim the exemption.
With Form 8332, you can claim the Child Tax Credit and the Additional Child Tax Credit. However, you still won’t qualify for the EITC or the Child and Dependent Care Credit.
Key Points to Remember
One Parent Only: Only one parent can claim a child as a dependent each year. Make sure to agree on who will claim the child to avoid issues.
Can't Revoke Quickly: If the custodial parent signs Form 8332, they can’t claim the child as a dependent for that year. They can only revoke this claim the following tax year.
Benefits of Claiming Dependents
Claiming a child as a dependent can have significant tax benefits:
Head of Household Status: This status gives a higher standard deduction and better tax brackets compared to filing as Single.
Child Tax Credit: This can reduce your tax bill by up to $2,000 per qualifying child, with up to $1,400 being refundable.
Education Credits: If your child is a student, you might qualify for education-related credits like the American Opportunity Tax Credit or the Lifetime Learning Credit.
Source: IRS 2023 Filing Requirements Chart for Most Taxpayers
Special Situations
Equal Custody: If you and your ex share custody equally, you need to decide who will claim the child each year. Alternating years or following another agreed schedule is common.
Multiple Children: If you have more than one child, you might agree to split the claims, with each parent claiming a different child, depending on what’s most beneficial.
5. Alimony and Child Support
Alimony payments and their tax implications depend on the date of the divorce agreement:
Before 2019: Alimony payments are deductible for the payer and taxable for the recipient.
After 2018: Alimony payments are not deductible for the payer nor taxable for the recipient.
Child support payments, on the other hand, are not deductible by the payer and are not considered taxable income for the recipient.
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6. Property Transfers
When it comes to property transfers as part of a divorce, there are specific tax rules you need to be aware of. Generally, property transfers between spouses during a divorce are not taxable. However, it's crucial to handle and report these transactions correctly to avoid potential tax issues.
Special Considerations
Retirement Accounts: Special rules apply to the transfer of retirement accounts. These transfers should be done under a Qualified Domestic Relations Order (QDRO) to avoid tax penalties.
Home Sales: If you sell a jointly owned home as part of a divorce, the capital gains exclusion for the sale of a primary residence can still apply, but both parties must meet the ownership and use tests.
7. Retirement Accounts and IRAs
Proper handling of retirement accounts ensures that both parties receive their entitled share without unnecessary tax penalties.
Qualified Domestic Relations Order (QDRO)
A QDRO is a legal order following a divorce or legal separation that splits and changes ownership of a retirement plan to give the divorced spouse their share of the asset. Here’s how it works:
Retirement Plans: A QDRO is necessary for dividing qualified retirement plans, such as a 401(k) or pension plan. The QDRO must be approved by the plan administrator.
Avoiding Taxes and Penalties: Transfers made under a QDRO are not taxable and do not incur the early withdrawal penalty, provided the funds are rolled over into an IRA or another qualified plan.
Special Considerations
Early Withdrawals: Any withdrawals taken before the divorce is finalized and without a QDRO or proper transfer can result in taxes and penalties.
Valuation and Division: It’s crucial to accurately value the retirement accounts and agree on a fair division. This often requires the help of a financial expert or attorney who specializes in divorce.
8. Deductions and Credits
After a divorce, your eligibility for certain tax deductions and credits may change. Understanding these changes can help you optimize your tax situation and avoid unexpected liabilities.
Changes to Itemized Deductions
Mortgage Interest and Property Taxes: If you previously itemized deductions for mortgage interest and property taxes, your ability to claim these may change if you no longer own the home or if you are no longer responsible for paying these expenses.
Medical Expenses and Charitable Contributions: The loss of joint income may impact your ability to itemize deductions for medical expenses and charitable contributions. It’s essential to review your expenses and determine if itemizing still benefits you.
Legal Fees
Non-Deductible: Generally, legal fees related to obtaining a divorce are not deductible. However, fees paid for tax advice related to the divorce and for obtaining alimony can be deductible.
Documentation: Keep detailed records of any legal fees and consult a tax professional to determine what, if any, portion may be deductible.
Credits
Child Tax Credit: The custodial parent (the parent with whom the child lives for the majority of the year) typically claims the Child Tax Credit. However, the noncustodial parent may claim the credit if the custodial parent signs a waiver (Form 8332).
Earned Income Tax Credit (EITC): Only the custodial parent can claim the EITC. This credit is based on income and the number of qualifying children, providing significant tax savings for low to moderate-income earners.
Dependent Care Credit: This credit is available to the custodial parent to help offset the cost of daycare or other dependent care expenses, allowing them to work or look for work.
Work With a Tax Expert
Investing in a tax professional’s services is a smart move during a divorce. They can help you navigate the complexities of the tax code and ensure that you’re maximizing your tax benefits during this challenging time. Remember, when it comes to dealing with the IRS, having an expert on your side can make all the difference.
Why Hire a Tax Professional?
Expertise and Knowledge: Tax professionals stay up-to-date with the latest tax laws and regulations, including those specific to divorce. They can identify tax-saving opportunities that you might miss on your own.
Objective Perspective: When you’re dealing with the emotional and financial turmoil of a divorce, it can be hard to see things clearly. A tax advisor offers a fresh perspective and can help you make informed decisions.
Time and Stress Savings: Handling your own taxes can be time-consuming and stressful, particularly when dealing with the changes brought on by a divorce. A tax professional can take this burden off your shoulders, allowing you to focus on other important aspects of your life.
Avoiding Mistakes: Tax laws are complex, and making mistakes can be costly. A tax advisor can help ensure that your tax return is accurate and complete, reducing the risk of errors and potential audits.
Bottom Line
Divorce brings significant changes to your tax situation, but understanding these eight key points can help you navigate the process with confidence. Consider consulting a tax professional to ensure you are making the best decisions for your financial future. They can provide personalized advice and help you maximize your tax benefits during this challenging time.
Navigating the financial aftermath of a divorce can be daunting, but you don’t have to do it alone. At One Advisory Partners, our CERTIFIED FINANCIAL PLANNER™ professionals are ready to assist you with personalized, expert advice tailored to your unique situation. Visit our website today to learn more about how we can help you achieve financial stability and peace of mind during this challenging time.
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Reference
https://www.irs.gov/pub/irs-pdf/p504.pdf
https://www.irs.gov/pub/irs-pdf/p5854.pdf