Our Monthly Tip, as featured in Family Lawyer Magazine:
Here are some key tax issues you should discuss with your advisors before finalizing your divorce.
1. Reevaluate tax filing status
An individual’s tax filing status is used to determine several factors on the tax return, including the tax rate. A person’s marital status on the last day of the tax year determines the filing status for that entire tax year; an individual will be considered divorced for the entire year if the divorce was finalized on or before December 31 of the tax year. A divorced individual can use the Single or Head of Household filing status for the tax year in which the divorce was finalized.
Taxpayers not legally divorced or separated on December 31 are considered married for that tax year and will have the option to file their tax returns as Married Filing Jointly, Married Filing Separately, or Head of Household. The Married Filing Jointly filing status will usually result in a lower overall tax bill, but many individuals don’t want to work with their spouse to get the return filed as they may disagree on factors that impact the return. If you are in this situation, your next best option may be the Head of Household filing status. An individual is eligible to file as Head of Household if:
- They are not married, or are legally separated at the end of the tax year, or did not live with their spouse for the last six months of the tax year;
- They paid for more than one-half of the costs to maintain the household; and
- The individual’s children qualify as dependents and live with the taxpayer for more than one-half of the year.
A tax advisor can work with you to determine the most advantageous filing status for your circumstances.
2. Determine how to divide taxable income
If you have been filing a return jointly with your spouse since you were married, you have reported all your income on the same tax return without having to determine what income belonged to each spouse. When divorcing, you will need to determine your income separately so that each spouse reports the appropriate amount of income.
Determining the proper allocation of income and deductions in the tax year a divorce is finalized—or when a divorcing couple chooses to file separately—is typically dependent on the distribution laws of the state where the divorce decree was issued. Individuals in most community property states are required to split all community income equally up to the date of the divorce decree. After the divorce has been finalized, all income from that date through the end of the tax year is reported by the individual who earned it. Those divorcing in an equitable distribution state will usually report all income they earned individually, and any income received from property they own personally.
3. Agree who gets a tax refund
An overpayment on your prior year tax return that has been applied to the following year’s estimated tax, and estimated tax payments that have been paid during the tax year, can be allocated between spouses.
The IRS allows taxpayers to allocate these payments in any agreed upon manner if an explanation for the allocation is attached to the tax return when it is filed. The distribution laws in your state may dictate the allocation of these payments. The payments will likely have to be allocated equally to each spouse if the divorce is in a community property state and the tax payments were made with community funds. The laws for equitable distribution states may require that any estimated tax payments are divided between spouses in proportion to each spouse’s separate tax liability.
4. Avoid a surprise in alimony taxation
The Tax Cuts and Jobs Act legislation changed the tax treatment of alimony. It used to be that alimony was includable in the income of the person receiving the alimony and deductible by the payor. With the payor likely to be in a higher income tax bracket than the recipient, pushing the income down to be taxed in the recipient’s lower bracket often resulted in tax savings for the couple. As a result of the change, any divorce or separation agreement signed on or after January 1, 2019 is governed by the new tax laws; alimony income is not taxable to the recipient and there is no tax deduction for alimony paid. Divorces and separation agreements completed by December 31, 2018 are grandfathered and alimony continues to be deductible by the payor. However, there is a potential hidden trap for the unwary. The new laws are keyed to the date of a divorce or separation agreement: if a prenuptial agreement was signed before 2019—even if it was negotiated on the premise that alimony payments would be deductible to the payor—the parties will likely be subject to the new tax laws if they divorce after December 31, 2018. While pre-2019 prenuptial agreements can be reopened and renegotiated on this issue, that may also open the door to renegotiation on other issues.
5. Understand embedded taxes
Assets can be taxed differently, even when they seem to be comparable assets. One example is the division of retirement assets such as a 401k or IRA. Traditional IRA and retirement plan assets are taxable when the assets are distributed to the beneficiary, but Roth IRA assets are distributed to the beneficiary tax-free—a huge difference. It is also important to consider the cost basis of assets received in divorce, like stocks or real estate, since some assets may have built-in gains that will be realized when the asset is sold. For example, it is important to know the cost basis of any real estate received along with any tax deductions that have been claimed on the real estate, such as depreciation, to determine the capital gains tax consequences on the sale. A financial advisor can help you model out and quantify tax impact, which can be key data to leverage in divorce negotiations.
6. Evaluate your post-divorce cash flow
Determining your projected post-divorce cash flow can be essential in divorce planning. An analysis of projected cash flow enables you to determine if a proposed divorce settlement will allow you to maintain your current lifestyle by considering your anticipated income, spending, and taxes. A sophisticated financial advisor can analyze simulated asset division scenarios to project estimates of your annual cash flow and the length of time that your assets will last based on your anticipated living expenses and tax exposure. This type of cash flow analysis can help you at the negotiating table as well as help you to feel confident in your financial future.
These six key issues underscore how important it is for you to partner with the right team of advisors to navigate the tax issues associated with divorce, take advantage of opportunities, maneuver around potential traps, and generally position yourself for success.
Please visit our Matrimonial and Divorce Advisory Solutions resource page for more timely divorce planning content.
This article is for general information only and is not intended as an offer or solicitation for the sale of any financial product, service, or other professional advice. Wilmington Trust does not provide tax, legal or accounting advice. Professional advice always requires consideration of individual circumstances.