Important Tax Considerations During Divorce
Know someone who is going through a divorce? They will likely have to make many decisions regarding taxes during the process. It’s important, therefore, that they have a good understanding of the basics so that they can make informed decisions for their future.
Here are a few of the most common questions:
1. Is there tax on a divorce settlement?
Transferring assets between spouses because of a divorce does not generally result in a tax consequence.
2. Should my friend file jointly or separately?
Your friend’s marital status on December 31st determines their filing status that year. Couples sometimes wait until January to finalize the divorce to reduce taxes owed for the preceding year. This works whether they’re filing jointly or married filing separately for that year.
3. What is the Head-of-Household filing status?
To claim head-of-household status, your friend must be legally single, pay more than half of the household expenses, and have either a qualified dependent living with them for at least half the year or a parent for whom they pay more than half their living expenses.
4. What are the tax differences to consider when dividing qualified versus non-qualified assets?
Ordinary income rates apply on raising funds in a qualified plan, whether it’s needed to fund current living expenses or at some point in the future. Keep in mind there is potentially a 10% penalty if funds are withdrawn from a qualified plan when the individual is under age 591/2.
Capital gains rates apply on withdrawals from non-qualified accounts, typically less ordinary income taxes. Also, in selling positions to raise funds, one is taxed only on the gains booked, not the full withdrawal, as is the case for distributions from a qualified account.
Recognize that dividends and interest earned in an investment account, as well as capital gains distributions, are taxable in the year received. They are not taxed until withdrawn from tax-deferred accounts.
When deciding on the split of an investment account, pay attention to the securities’ cost basis (purchase price).
Pro tip: Be sure the settlement agreement addresses who is to receive any tax refunds, loss carryforwards, or tax debt.
Bonus Pro Tip: In situations where it makes sense, in the final year of filing a joint return, obtain a CPA that will project how much each spouse owes based on their respective income. Splitting the taxes owed in half may not be reasonable, depending on the circumstance. A situation where this might apply is a dual-income family and/or when the spouses have been living separately, supporting only themselves. The same would apply to the division of tax refunds, penalties, deductions, and the claiming of dependents.
As taxes can get complicated during a divorce, it’s important that your friend seek the help of professionals familiar with both the legal aspects of divorce as well as taxes. Reach out to a member of the BDF Team for further information on their specific situation.
Jenny is a Wealth Manager at BDF. She uses her background as a teacher to help individuals and families feel comfortable with their investments and planning. She also works on the firm’s Divorce Practice Group which helps divorcing individuals navigate the process and works closely with them afterwards to help them build a full life.