5 Tax Issues to Understand Before Your Divorce

5 Tax Issues to Understand Before Your Divorce

Divorce is not just a significant emotional journey but also a complex financial undertaking. You’re separating your household, so you need to update your budget for housing, living expenses, and retirement planning. It can be easy to forget in the midst of everything else, but you should prepare for changes to your taxes, too. 

If you’re contemplating the end of your marriage, it’s crucial to understand how this life-changing decision might impact your tax bill. Let’s explore the relationship between divorce and taxes, providing five essential considerations that couples should be aware of before making their decision.

1. Tax Filing Status Changes

The most immediate tax implication of divorce is the change in filing status. You are no longer eligible to file jointly once your divorce is finalized. Instead, you will move from a “Married Filing Jointly” or “Married Filing Separately” status to either “Single” or “Head of Household” if you qualify. 

The income thresholds for tax brackets differ between filing statuses. Typically, single filers have narrower brackets compared to married couples filing jointly. You may enter a higher tax bracket more quickly as a single filer, potentially leading to a higher tax rate on additional income.

Additionally, the standard deduction amount changes based on your filing status. For single filers, the standard deduction is lower than for married couples filing jointly. This means the portion of your income that is not subject to tax is reduced after divorce, which can increase your taxable income.

2. Alimony and Child Support

For divorces finalized after December 31, 2018, the IRS treatment of alimony has changed. Under the Tax Cuts and Jobs Act, alimony payments are no longer deductible by the payer and are not considered taxable income for the recipient. This contrasts with the previous law, where alimony was deductible for the payer and taxable for the recipient. This change does not apply to divorces finalized before 2019.

However, child support payments are not deductible by the payer and are not taxable income for the recipient. This understanding has remained consistent and has not been impacted by the Tax Cuts and Jobs Act.

3. Division of Assets

The division of marital assets can have significant tax implications. Divorcing couples often need to divide their assets, which can include property, investments, and retirement accounts. The transfer of these assets during a divorce is generally not a taxable event.

However, future sales of assets like real estate or stocks can trigger capital gains taxes, which will be the responsibility of the individual who owns the asset post-divorce. For instance, transferring certain assets, such as stocks or property, may trigger capital gains taxes that the owner must pay upon their sale. 

Similarly, if one spouse keeps the marital home, only they can claim the mortgage interest and property tax deductions. This loss can represent a significant change for the non-claiming spouse, affecting their overall tax liability. On the other hand, single filers can only exclude up to $250,000 of gain from the sale of a primary residence, as opposed to $500,000 for married couples filing jointly. This difference can have a significant impact on your IRS liability from the sale.

4. Retirement Accounts and Pensions

Dividing retirement accounts and pensions can be complex and requires careful planning. Instruments like a Qualified Domestic Relations Order (QDRO) may be needed to divide assets in a 401(k) or pension plan without incurring early withdrawal penalties. However, withdrawals made after the division are typically taxable to the recipient. 

Furthermore, single filers may have different income phase-out ranges for IRA contribution deductibility, especially if they are covered by a retirement plan at work. It’s crucial to understand the IRS rules governing the specific types of retirement accounts involved to minimize the impact of a divorce on your retirement plans.

5. Tax Credits and Deductions for Dependents

Divorce can significantly impact tax credits and deductions related to dependents, such as:

  • The Child Tax Credit (CTC): The Child Tax Credit is designed to help taxpayers with the cost of raising children. The credit amount has varied over the years due to legislative changes. Still, it provides a substantial reduction in tax liability for each qualifying child under a certain age (usually 16 years old).
  • Child and Dependent Care Credit: This credit helps offset the cost of child care for children under 13 or for a disabled spouse or dependent of any age. It applies to expenses incurred to allow the taxpayer to work or actively look for work. The credit amount depends on the taxpayer’s income, the number of dependents, and the amount of work-related child and dependent care expenses.
  • Earned Income Tax Credit (EITC): While not exclusively for those with dependents, the EITC is a significant credit for low- to moderate-income working individuals and couples, particularly those with children. The credit amount increases with the number of qualifying children and can result in a substantial reduction in taxes owed, often leading to a refund.

Determining which parent will claim the children as dependents is a crucial part of the divorce negotiations, as it affects eligibility for these benefits.

If you have a qualifying dependent, you may also be able to file as head of household, which offers more favorable tax rates and a higher standard deduction than filing as a single individual. However, this status has specific requirements, such as paying more than half the costs of keeping up a home for the year and having a qualifying person live with you for more than half the year. 

Helping You Handle Divorce and Taxes in California

Divorce can bring about a multitude of changes, not least in the realm of taxes. Couples must navigate these waters with a clear understanding of the financial implications of their decisions. Consulting with a divorce attorney and a tax professional can provide valuable guidance in this complex area, ensuring that both parties make informed decisions that serve their long-term financial health. Remember, a well-informed decision today can prevent unintended financial consequences tomorrow. Contact the experienced family law attorneys at Rodriguez Lagorio LLP to learn how we can assist you with your divorce.