What Should My Tax Plan for Divorce Include?

Failing to address the tax consequences of decisions made during a divorce can lead to unexpected liabilities and financial strain. Proactive tax planning allows both parties to understand and prepare for the tax impact of their settlement. This protects their financial well-being and ensures compliance with IRS regulations.

Determining Filing Status and Claiming Dependents

Your tax filing status for an entire year is determined by your marital status on December 31st. If your divorce is legally finalized on or before that date, you are considered unmarried for the whole year and must file as either Single or Head of Household. The Head of Household status is more advantageous, offering a higher standard deduction and more favorable tax brackets. To qualify, you must be unmarried for the tax year, have paid more than half the cost of keeping up a home, and have a qualifying child or relative who lived with you for more than half the year.

If your divorce is not final by December 31st, you are still considered married for tax purposes. Your options are Married Filing Jointly or Married Filing Separately. A joint return results in a lower tax liability but creates joint and several liability for the entire tax bill, including any deficiencies or penalties. Filing separately leads to a higher combined tax bill and disqualifies you from certain tax benefits, but it separates each spouse’s liability.

The ability to claim a dependent child impacts eligibility for tax benefits like the Child Tax Credit. The custodial parent—the parent with whom the child resides for the greater number of nights—is the one entitled to claim the child.

An exception allows the noncustodial parent to claim the child if the custodial parent signs IRS Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent. The noncustodial parent must attach this form to their tax return. This arrangement is often used as a negotiation tool, especially if the noncustodial parent is in a higher tax bracket and would gain a greater financial benefit.

Tax Implications of Alimony and Child Support

The tax treatment of alimony was altered by the Tax Cuts and Jobs Act (TCJA) of 2017. The rules that apply depend on the date your divorce or separation agreement was executed.

For Divorce or Separation Agreements Executed After 2018

For any divorce or separation agreement finalized on or after January 1, 2019, alimony payments are not tax-deductible for the payer. The payments are also not considered taxable income for the recipient. This structure means the payer uses after-tax dollars and the recipient receives the funds tax-free. Both parties should recognize this during negotiations, as the payer receives no tax benefit for the payments.

For Divorce or Separation Agreements Executed Before 2019

For agreements executed on or before December 31, 2018, the previous tax rules apply. Under this framework, alimony payments are tax-deductible for the payer and are considered taxable income for the recipient. These pre-2019 agreements can be formally modified to adopt the new rules, but the change must be explicitly stated in a written modification to the original divorce instrument.

Regardless of when a divorce was finalized, the tax treatment of child support is constant. Child support payments are never tax-deductible for the parent who pays them, and they are never considered taxable income for the parent who receives them. The IRS views child support as a personal expense for the benefit of the child.

Navigating the Division of Marital Assets

The division of property has tax consequences tied to different assets. Understanding the rules for transferring property like real estate and investments helps prevent future tax bills. While transfers during a divorce are tax-neutral, the underlying tax attributes of the assets carry forward to the receiving spouse.

The Marital Home

When a primary residence is sold, the tax code allows for a capital gains exclusion if certain ownership and use tests are met. A married couple filing jointly can exclude up to $500,000 of gain, while a single individual can exclude up to $250,000. To qualify, you must have owned and lived in the home as your main residence for at least two of the five years before the sale.

If a couple sells the home while married, they can use the full $500,000 exclusion on a joint return. If the home is transferred to one spouse in the divorce and later sold, that spouse can claim the $250,000 exclusion. An exception may allow both to claim an exclusion based on their combined history if the divorce decree grants one spouse continued use of the home.

Retirement Accounts

Dividing retirement savings requires specific procedures to avoid immediate taxation and penalties. For employer-sponsored plans like 401(k)s, a Qualified Domestic Relations Order (QDRO) is required. A QDRO is a legal order that recognizes an alternate payee’s right to receive a portion of a plan participant’s benefits.

When funds are transferred via a QDRO, the receiving spouse can roll the money into their own retirement plan tax-free. A cash distribution is subject to income tax, but the 10% early withdrawal penalty is waived. For Individual Retirement Accounts (IRAs), a QDRO is not required. A tax-free transfer can be made if it is designated as “incident to divorce” in the divorce decree.

Other Investments (Stocks, Bonds, Mutual Funds)

When investments like stocks or bonds are transferred between spouses during a divorce, there is no immediate tax consequence due to the concept of “transferred basis.” This means the original cost basis and holding period of the asset transfer to the receiving spouse. The cost basis is what was originally paid for the asset and is used to calculate capital gain or loss upon its sale.

The receiving spouse is responsible for paying capital gains tax upon selling the asset. For example, if stock purchased for $20,000 is now worth $100,000, the receiving spouse’s cost basis is $20,000, and they will owe tax on the $80,000 gain when they sell. This deferred tax liability should be considered when negotiating the asset division.

Adjusting Your Tax Strategy After the Divorce

After a divorce is finalized, you must update your tax strategy to reflect your new financial situation. A few proactive steps can prevent tax bills or underpayment penalties.

A primary step is to update your tax withholding. Since you will now file as Single or Head of Household, submit a new Form W-4, Employee’s Withholding Certificate, to your employer. This adjusts the federal income tax withheld from your paycheck to reflect your new filing status and financial situation.

You may also need to begin making quarterly estimated tax payments to the IRS. This is common if you receive income not subject to withholding, such as taxable alimony from a pre-2019 agreement or capital gains from selling assets. Failing to make these payments can result in an underpayment penalty.

Finally, conduct a thorough review of the beneficiary designations on all your financial accounts. This includes retirement accounts, life insurance policies, and payable-on-death accounts. These designations are not automatically voided by divorce, so failing to update them could result in your former spouse inheriting assets you intended for someone else.