Ten Timely Tax Tips For Divorcing Couples
"It's Not What You Get; It's What You Keep"
This Information Is Provided Courtesy Of Two Rivers Tax & Accounting Service
Stephanie Perrin, CPA
The devastating effects of divorce have exacted a heavy financial and emotional toll on many lives, especially during COVID-19 and extending through the long pandemic. A recent article in the New York Post notes that divorce rates have spiked in the U.S. during the pandemic, citing a combination of stress, unemployment, financial strain, death of loved ones, illness, homeschooling children, mental illnesses and more, resulting in greater strain on relationships.
While there are many stressful and life-altering financial, legal and emotional aspects to divorce, changes to financial status and tax liabilities certainly top the list. However, seeking the services of a CPA experienced with issues of divorce can minimize the risks and helps provide critical information to the decision-making process.
The compilation below is a cautionary alert to warn about potential pitfalls and often-overlooked items and issues.
- Marital Home & Mortgage Pitfalls – Decisions about who stays, who goes or whether or not to sell the marital home is huge. Areas for consideration are maintenance of the home, future income, potential rental income from the home, continuation of joint ownership and whether re-financing is even an option. Do not forget to require your spouse to remove your name from the joint mortgage as in the lender's eye, it is still your debt despite the divorce agreement/settlement. And most importantly, remember that the deed & the mortgage are not the same. Coming off the title to the home is different from coming off the mortgage. If considering joint ownership of the home, clearly defined agreements for the payment of mortgage, taxes, insurance, repairs and other costs are needed, including future sale of the home and right of first refusal if parties are in disagreement about selling. Spousal support & child support, if applicable, require a 6-month history of payment and 3 years of continuance to be considered as qualified income for mortgage purposes. The income must be documented as reliable to the lender.
- Tax Filing Status – Tax filing status is based on your marital status on the LAST DAY of the tax year. If your divorce is finalized on December 31, then for all intent and purposes you are considered 'unmarried' for tax purposes. Options for unmarried individuals are 'Single' or 'Head of Household.' The IRS has established requirements for 'Head of Household' status: You must be unmarried; pay for more than 50% of household expenses; and have a qualified child or dependent. A major benefit of this designation versus 'Single' status is that you receive a larger standard deduction and can earn more money before moving into a higher tax bracket. If your divorce is not yet final by year's end, you have the option of filing a joint return and potentially saving money.
- Alimony – The tax treatment of alimony changed due to the Tax Cuts & Jobs Act. Alimony is now non-taxable. Previously it was treated as a tax deduction for the support payer and taxable income to the recipient.
- Employment & Spousal Compensation Packages – Discovery of your spouse's financial compensation can be tedious and tricky. It is best to get copies of W-2s, pay stubs and determine what type of compensation plans are in place including 401K plans, stock options and employee stock purchase plans. You also need to assess job stability for both you and your spouse as divorce can often lead to reduced performance in the workplace and/or job loss due to the stress, absences and other issues resulting from the divorce.
- Retirement Assets – Understanding pensions is important as different retirement accounts are not treated equally under tax laws. For instance, distributions from a regular 401K are taxable, but they are not under a Roth 401K. Putting a Qualified Domestic Relations Order (QDRO) in place prior to finalizing your divorce agreement is essential, as this document enables couples to divide a qualified retirement plan without any taxes. It needs to be signed by both parties and submitted to the plan administrator for approval in advance. And do not forget a 72 (t) (2) (c) distribution which allows you to access retirement funds and avoid any early withdrawal penalties. This is a one-time opportunity only to withdraw cash from your spouse's retirement plan and avoid the 10% early withdrawal penalty.
- Health & Life Insurance – If your spouse participates in an employer-funded plan, once the divorce is finalized, you will need to find your own health insurance. Premiums you pay directly are tax-deductible on federal taxes. You may also deduct health insurance premiums if you itemize deductions rather than taking the standard deduction; pay premiums directly, not through an employer, and if your medical expenses total more than 7.5% of your income for the tax year. Some health insurance plans have Health Savings Accounts attached, and these accounts can be divided in divorce cases. Life insurance is an important safety net, especially to protect against the loss of support payments if the supporting spouse dies prematurely. However, allowing the supporting spouse to own the policy can put the supported spouse in peril, since ownership means he or she can change the beneficiary or reduce the death benefit. If you are the supported spouse, transfer the existing policy into your name or purchase a new policy in your own name. Another caveat is not to overlook the cash value of the life insurance policy. Permanent life insurance has a cash value component.
- Dependent Children & Form 8332 – While it's common for the custodial parent to claim dependent children, he or she may declare through a divorce decree or separation agreement that the noncustodial parent may claim the dependent(s). If both parents claim the child, the IRS will apply tiebreaker rules to determine who the custodial parent is. The parent who does not qualify to claim the dependent will need to file an amended tax return. If there is no divorce or separation decree, the custodial parent can sign Form 8332 to release the tax claim for the dependent. However, the form can be revoked by the custodial parent, who can reclaim the tax deduction.
- Educational Tax Credits – Divorcing parents must first decide who claims the dependent child on income taxes. One parent can claim each year, or an agreement can allow for alternating years between parents. There are tax credits and deductions available including the American Opportunity Tax Credit; Lifetime Learning Credit; Tuition & Fees Deduction; and the Student Loan Interest Tax Deduction. In general, only one tax deduction will apply per child, so choose carefully. If you have multiple children in college, then one deduction per dependent child applies. Each deduction has specific requirements. 529 accounts are an investment vehicle to save for college expenses, but be aware that in most cases, only one individual can own and control the account. They cannot be titled jointly. That means the designated spouse could withdraw funds or use them for other purposes. Some 529 accounts can be divided into two separate accounts, however; there are penalties if funds are used for anything other than educational expenses. It is important to remember that a 529 is not owned by the beneficiary, so it is not considered your child's asset.
- Negotiation & Non-Negotiable Items – Be careful when divorce negotiations begin and understand that certain items are not negotiable, like Social Security. You either meet the requirements or you do not, so do not mistakenly be fooled into trading another asset for something you are legally entitled to. Additionally, certain agreements you make with your spouse might not be enforceable in a court of law. For instance, if you signed an agreement stating that child support can never be increased, your spouse can still petition the court to modify the support. The court will ignore your personal agreement as it is not court-ordered and does not carry legal power.
- Hidden Assets & Personal Property – Do not forget the value of your personal property like furnishings, artwork and collectibles or the value of 'hidden' assets like memberships to country clubs, golf clubs, fitness clubs, etc., credit card points, perks and frequent flier miles, timeshares, season ticket passes, and accounts like Paypal or Venmo which could have cash balances.