5 Mistakes People Make on Their Taxes During and After Divorce
- How getting divorced affects your taxes
- Alimony changes
- Splitting assets
- 5 mistakes to avoid during tax time
Getting divorced brings with it some uncertainty. You may feel anxious about lots of things: where you will live, who will be there for you, how much money you will have. You may worry about your tax situation, too. It's especially stressful if you're unclear about how getting divorced will affect your taxes.
Let's take a closer look.
How getting divorced affects your taxes
Indeed, getting divorced will affect your personal tax situation. For example, your filing status will change. If you previously filed as Married Filing Jointly, you'll now need to file as Single or Head of Household. The latter can provide more tax benefits, but certain criteria must be met, such as having a dependent living with you for more than half the year.
Some people change their filing status immediately when they decide to divorce. Others wait until the tax year following their divorce. Because this decision can have tax implications, it can be helpful to discuss your options with a financial advisor.
If you want to learn about Hello Divorce's certified divorce financial analyst (CDFA) services, including what a CDFA can do for you and how much it would cost to work with one, click here. While you're at it, feel free to schedule a free 15-minute call to learn about our CDFAs and other services.
Alimony payments have undergone significant changes due to the Tax Cuts and Jobs Act of 2017. Alimony is no longer deductible for the payer, nor is it considered taxable income for the recipient. This is a stark contrast to previous rules and can significantly impact both parties' financial situations.
Splitting assets during divorce can also have tax implications. While the transfer of property between spouses as part of a divorce agreement is typically tax-free, future sales of such assets may result in capital gains tax.
5 tax mistakes to avoid in divorce
1. Failing to agree on your date of separation
Your date of separation marks the point where your financial lives diverged. It's a crucial detail, concerning not just how you divide your assets but also how you report your income to the IRS.
If you're unable to agree on a date of separation, or if you misrepresent your income before and after this date, you could invite unwanted attention from tax authorities. For instance, if you report combined income as a married couple for a period when you were in fact separated, it may appear as though you are under-reporting your individual income. This discrepancy could trigger an audit, which can be stressful, time-consuming, and potentially costly.
Any financial decisions or transactions made after your date of separation are typically considered separate. For example, if you purchased a piece of furniture after separating, that furniture would be considered your personal property rather than shared marital property – and if you still owe money on the furniture, that debt would be considered yours alone.
Inaccuracies about your date of separation could lead to confusion about what is communal and what is separate property and debt.
2. Failing to understand the dependency exemption
The Tax Cuts and Jobs Act of 2017 changed the dependency exemption. It temporarily eliminated the personal exemption amount for dependents but increased the child tax credit. As it stands now, you cannot claim a dependency exemption for your child on your taxes. However, determining which parent claims the child tax credit is crucial. This credit can provide substantial tax savings, particularly to parents of young children.
Here's where it gets interesting: The current law is set to expire at the end of 2025. If Congress does not extend these changes, the dependency exemption will return in 2026. If that happens, parents will once again be able to claim an exemption for each dependent, reducing their taxable income.
Failing to understand these nuances could lead to missed opportunities for tax savings. It could also lead to disputes with your ex-spouse over who gets to claim the children. So, stay informed, and plan ahead.
Consult with a tax advisor or a family law professional to understand how these changes impact your specific situation and how to prepare for potential shifts in the tax landscape post-2025.
3. Failing to correctly change your name
It might seem like a minor detail in the grand scheme of divorce proceedings, but failing to correctly change your name with all necessary institutions could lead to significant tax complications.
Let's break it down.
When you change your name due to divorce, it's not enough to just update your social media profiles and driver's license. You must also inform the Social Security Administration (SSA). Why? Because the IRS matches names and Social Security numbers on tax returns. If your new name doesn't match SSA records, it could delay your tax return processing and any potential refunds.
Even if you're not expecting a refund, this mismatch could lead to unnecessary headaches. The IRS might question the validity of your tax return or, worse, suspect you of identity fraud.
To avoid these issues, promptly update your name with the IRS and all financial and state institutions. Ideally, your divorce decree will state your name change, and you can provide a copy of that to any government agencies when requesting your name change.
Read our article, Don't Forget to Notify These 19 Agencies after You Change Your Name, for a checklist of the entities that must be notified after you change your name.
4. Failing to properly split retirement funds
During a divorce, retirement funds are often divided between spouses. This division, if not done properly, can lead to an unwelcome surprise from the IRS. Early withdrawal penalties, ordinary income taxes, and potential underfunding of your retirement nest egg are all on the table.
For instance, if you take money out of your 401(k) or traditional IRA before age 59 1/2 without a proper court order, the IRS will likely tag you with a 10% early withdrawal penalty, not to mention the regular income tax you'd owe on the withdrawal.
Thankfully, there is a solution: the Qualified Domestic Relations Order (QDRO). A QDRO is a court order that allows funds to be distributed from a retirement account to an ex-spouse without incurring the early withdrawal penalty. However, the recipient will still owe income tax on the money unless it's rolled over into another qualifying retirement account.
5. Failing to file under the right status
Your filing status determines which tax rates apply to you and how much of a standard deduction you can claim. The wrong status could result in you paying more tax than necessary. Or worse, it could trigger an audit by the IRS.
So, which status should you choose? If your divorce is finalized by December 31 of the tax year, you can no longer file as "Married." You'll have to select "Single" or, if you have dependents, "Head of Household," which offers more favorable tax rates and a higher standard deduction.
But remember, the devil is in the details. To qualify as "Head of Household," you must meet certain requirements. For example, you must have not been married on the last day of the year. You must have invested at least half of the total cost of your home upkeep for that year. Further, a “qualifying person” (like a child) must have been your co-resident for greater than half of the year.
Tax matters are rarely straightforward, especially in the aftermath of a divorce. But armed with the right information, you can navigate these waters with confidence. So, choose your filing status wisely. It's not just about ticking a box; it's about making the right choice for your financial future.