Whether you are in the process of getting divorced or are considering filing for divorce, there are a five (5) tax considerations you should be aware of as you move forward. As we are in the midst of tax season it is the perfect time to consider these tax issues to avoid potential pitfalls.
1. Hidden Taxes and Property Settlements: The transfer of assets between spouses incident to a divorce generally results in no tax consequences to either party. However, depending on the basis you/your spouse have in certain assets, there may be hidden tax consequences associated with the sale of assets such as real estate, investment holdings and business interests. These tax consequences may ultimately reduce the actual value of an asset that otherwise appears to be worth more at first glance.
In addition, there can also be hidden taxes associated with keeping a particular asset that you may otherwise believe is presently “tax free”. Specifically, traditional IRA accounts that hold investments in non-traditional or alternative assets (i.e. hedge funds, private-equity funds, limited partnerships, operating businesses, and real estate) can lead to present day tax consequences, even when the investment is an “allowed” investment. Thus, even though a traditional IRA is ordinarily allowed to be transferred tax free until the funds are withdrawn, the portfolio holdings cannot be overlooked.
When allocating assets at the time of the divorce, you should consider the hidden tax consequences contained in the assets you and your spouse hold are dividing. If you do not, then you may not be getting what you bargained for.
2. Taxability of Maintenance: Generally, maintenance is taxable to the recipient and deductible to the payor. As an exception to this general rule parties, by agreement, may change the taxability and/or deductibility of the payments. However, unless you and your spouse have specifically agreed to alter the taxability of the maintenance payments, a maintenance recipient should make estimated tax payments and set aside money for the ultimate income tax which may be owed. Additionally, assuming the tax deductibility of maintenance has not been altered, in order to free up cash throughout the year, a maintenance payor should consider adjusting withholdings/estimated payments to reflect what the actual tax liability will be given the deductibility of the maintenance.
3. Allocating Dependency Exemptions: The Internal Revenue Service rules generally state that the parent with primary parenting responsibility is entitled to claim the children as dependency exemptions on his/her tax return. The primary exception to this rule is when the custodial parent allocates the children to the non-custodial parent with a written document (IRS Form 8332) and that document is used by the non-custodial parent with his/her tax return. The allocation of these exemptions and the corresponding value of the same should be addressed in the final divorce decree, including the obligation to execute any necessary forms/documents to allocate the children accordingly. Starting July 1, 2017 a new child support law is set to take effect which expressly permits a court to allocate the exemptions between the parties, although this will not eliminate the need to file the appropriate forms with the IRS. These valuable exemptions should be considered as part of the overall allocation of income between the parties.
4. There May Be a Way to Access Retirement Funds Early Without The 10% Penalty: Early or pre-retirement withdrawals from a retirement account typically result in a 10% tax penalty in addition to ordinary income taxes. When the account is divided in a divorce, this penalty can be avoided if the transfer of funds is done pursuant to Qualified Domestic Relations Order (QDRO). The recipient of QDRO funds (i.e. the non-retirement account owner/holder) has the one time election at the time the account is being divided to take all or a portion of the funds out as cash. If that election is made, ordinary income tax will be charged but the 10% penalty for early withdrawal will not apply. Since not every retirement account or plan can be divided with a QDRO, not every plan will allow for this. If you do have the right type of retirement account, this may be a way to access retirement funds early without penalty, especially if there is a short term need for a cash infusion.
5. Filing Status the Year of Divorce and Tax Refund/Liability: People are not able to file joint tax returns for the year in which they get divorced. . Thus, if the divorce is at the end of the year, adjust withholdings to account for this tax filing status change. Otherwise, this could result in an unanticipated tax liability. If the divorce is earlier in the year, while this may not make a substantial difference, it is a consideration nonetheless. Additionally, the tax refund (or liability) a party may be entitled to for the year of the divorce, even if on a prorated basis, should also be considered in negotiating a settlement. The tax implications of the filing status change and the potential tax refund/liability at the time of divorce should be considered as part of the overall resolution of your case.
By taking these tax considerations into account, you can minimize potential pitfalls. If you have not done so already, have a discussion with your divorce attorney about the tax implications of your divorce and, when appropriate, consult with other financial professionals (i.e. accountant, financial advisor, estate planner, etc.) to make sure you are getting what you bargained for.