Editor’s Note: Today’s post comes from Nicole Green, owner of Strataxtic. Strataxtic is a sponsor on the site but is not paying to have this post published. All guest posts, even those from partners, have to meet editorial guidelines to be published. We asked Nicole to tell us what we need to know about the tax implications of getting divorced.
Will you have this man to be your husband, to live together in holy marriage? Will you love him, comfort him, honor, and keep him in sickness and in health, and forsaking all others, be faithful to him as long as you both shall live? If you are married, you know these words (or a variation of them), all too well. For some, these words echo in your mind as it may have been one of the happiest days of your life, but the reality is, sometimes this happiness turns to sadness as couples grow apart, which often leads to a legal separation and eventually a divorce. Recently, I read a statistic that divorce rates have spiked because of Covid-19; whether this is fact or fiction, if you find yourself in this situation, here are some tax implications that you will likely encounter.
Before we discuss the post issues of a divorce, let’s talk about some pre-divorce considerations.
Will your divorce deepen or expose possible income tax issues?
Make sure you are in compliance with your federal and state tax returns. It is important to know if you are under the gun to meet a filing deadline. Why? For unfiled tax returns with a claim for credit or refund of an overpayment, the statute of limitation is 3 years or 2 years from the time the tax was paid, whichever is later. (I.R.C. § 6511(b)) If you miss this deadline, you have forfeited your refund, and have just handed Uncle Sam and your state a gift. I must point out that for unfiled tax returns (for which you may owe the IRS), the statute never starts. (I.R.C. § 6501(c)(3))
It is in your best interest to find out if there are unpaid taxes because of unreported income or improper deductions or credits that were omitted from a jointly filed tax return that you did not know of or had to reason to know of. This is especially troubling if you are not jointly and severally responsible. Thus, figure out any potential tax exposures that were allocated to you and will continue to stay with you after the divorce is final. While there is relief available through the IRS based on the facts and circumstances, that is outside the scope of this article.
The IRS default rule is that if a divorce decree is silent regarding the dependency exemption, it remains with the custodial parent. (I.R.C. § 152(e)) If kids are involved in the union, you need to decide who will claim which kid after the separation. Will you split the dependents or alternate years? After your divorce, you will likely file as single, but if you have a dependent, you can claim the more favorable head of household status; this is discussed in more detail below under “filing status”. Regardless, if you are going through an amicable divorce, it may be wise to come to an agreement that the most advantageous filer claim the children and you divide the savings.
You are now at the point of your divorce, what should you consider? Here are some post-divorce considerations.
Is Alimony taxable to the recipient and deductible to the payee?
Depending on the state in which you reside, you may contend with support/alimony provisions. When one spouse makes support/alimony payments to the other upon a divorce, the deductibility of the payments by the payor and the taxability to the payee depends on when the divorce or separation was executed.
- For divorce or separation that is executed post-2018, alimony and separate maintenance payments are not deductible by the payor spouse and are not includible in the gross income of the payee spouse. (Sec. 11015(c) of the Tax Cuts and Jobs Act)
- For divorce or separation that is executed pre-2019, alimony or separate maintenance payments are deductible by the payor, and taxable to the payee, as long as the payments qualify as “alimony” as defined by the tax rules. (I.R.C. § 215(a))
Property transferred between spouses incident to a divorce results in nonrecognition of gain or loss and the carryover basis rule applies. (I.R.C. § 1041) This is the case for most types of property transferred in a divorce, not just to the marital home; we will discuss more on this later. In general, if a married couple sells their home in connection with a divorce or legal separation, there are no tax implications on gains of up to $500,000, assuming the said property was owned and used as the principal residence for two of the previous five years.
If one spouse continues to live in the home and the other moves out but remains an owner of the home, you may still be able to avoid gain on the future sale of the home up to $250,000 each, but special language may have to be included in the divorce decree or separation agreement to protect the exclusion for the spouse who moves out. One point to add is that if the couple doesn’t meet the two-year ownership and use tests, any gain from the sale may qualify for a reduced exclusion. (I.R.C. § 121)
A spouse’s pension benefits are often part of a property settlement. In this case, the commonly preferred method to handle this is to get a qualified domestic relations order (QDRO). A QDRO gives one spouse the right to share in the pension benefits of the other and taxes the spouse who receives the benefits. Without a QDRO, the spouse who earned the benefits will still be taxed even though they are paid out to the other spouse. (I.R.C. § 402(e)(1)(A))
A QDRO is not needed to split up an IRA, but special care must be taken to avoid unfavorable tax consequences. For example, if the IRA owner cashed out the IRA and then paid the ex-spouse the share of the IRA stipulated in a divorce decree, this transaction could be treated as a taxable distribution to the owner of the IRA. However, one tax strategy to avoid this is for the payor to use an IRS-approved method for transferring the IRA. Thus, consider a tax-free transfer from one spouse’s IRA to the other spouse’s IRA in a trustee-to-trustee transfer. (I.R.C. § 408(d)(6)) Finally, it may be wise to delay this transfer until after the divorce or separation is final, to avoid a taxable event.
It is imperative that you follow the timelines for withdrawals from a 401(k) incident to a divorce. The spouse that holds the 401(k) is responsible for submitting necessary paperwork to the plan administrator in a timely manner. If you are the receiving spouse, you should receive a response from the plan in a matter of days. With a QDRO in place, you have the right to inquire about your spouse’s benefits. Thus, if a significant time has passed, it is advisable to follow up with the plan administrator to ensure the required steps are taken for a smooth transfer of your share of the 401(k).
For example, if the 401(k) funds will be transferred to a rollover IRA, the QDRO needs to spell that out; this will result in a nontaxable trustee-to-trustee transfer event for both the 401(k)-account holder and the recipient. Some ex-spouses may choose to receive the money directly instead of transferring it to a rollover IRA. A divorce is one of the few times that 401(k) funds can be accessed before age 59½ without incurring an early withdrawal penalty of 10 percent (I.R.C. § 72(t)(2)(C)), however, the recipient would still have to pay ordinary income taxes on the money. It is important that this type of distribution is specified in the QDRO. (I.R.C. § 414(p)(1)(B))
Finally, in very rare occasions, a 401(k)-withdrawal due to divorce can be handled outside of the court system. You and your spouse can come to an agreement about dividing your 401(k) at the time of your retirement, especially if you both decide to leave the money in the account until you reach 59½.
Your tax filing status is dictated by your marital status on December 31st. Thus, the timing of your divorce or separation can have an impact on how you file your tax return. If a final decree of divorce is issued by the end of the year, your filing status will be single, assuming you did not remarry. Yes, I have seen situations where a divorce and marriage occur in the same year. However, if you provide more than half of the costs of a household for a dependent, you may qualify for a more favorable “head of household” status. (Treas. Reg. §1.2-2(b)) If a decree is not issued by year-end, you are treated as married even if you are separated from your spouse under a separation agreement or nonfinal decree. As such, you may still file jointly with your spouse or married filing separately. Keep in mind that the latter is the least favorable filing status, tax wise.
One important consideration is that if you lived apart from your spouse during the last six months of the year and you maintain and provide more than fifty percent of the support for a dependent, you could also qualify for the more favorable head of household filing status. (Treas. Reg. §1.2-2(c)) While this is not an all-inclusive list of tax implications incident to a divorce, it is a starting point to have the conversation with your Attorney and Tax Advisor.
Joshua Holt is a practicing private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.