As if divorce doesn’t cause enough emotional and financial turmoil, every person going through a divorce must also consider a variety of tax issues that arise once a marriage ends. Many of these issues can catch a divorcing spouse off guard. It is important to understand these tax pitfalls in order to make sound decisions and avoid unnecessary troubles down the road.
Alimony is Taxable to the Recipient
With some exceptions, spousal support paid by one party to the other is usually considered a taxable event for both. This is crucial to understand because it causes a tax liability for the payee spouse and a tax credit for the payor spouse.
The IRS sets forth specific criteria in order for a payment between spouses to qualify as alimony:
The spouses do not file a joint tax return with each other
The payor spouse pays in cash (including checks, bank transfers or money orders)
The payment is received by (or on behalf of) the payee spouse
The divorce or separate maintenance decree does not state that the payment is not alimony
If legally separated, the former spouses are not members of the same household when the payment is made
There is no liability to make payments after the death of the payee spouse
The payment is not treated as child support or part of a property settlement
Who Gets the Dependency Exemption for the Minor Child
The IRS presumes that the custodial parent will receive the dependency exemption for any minor children of the divorcing couple. A custodial parent is defined as the parent who has the minor children for the greater portion of the calendar year. This presumption can create a situation where one parent always gets the deduction, year after year, providing significant tax savings to him or her.
However, the dependency exemption can be allocated by agreement of the parties or by court order. In such cases, the parent relinquishing the dependency exemption is required to sign IRS form 8332, which is then attached to the non-custodial parent’s tax return in each year that he or she claims the exemption.
Tips for Financial Security After Divorce Settlement
Meet with an Lawyer
Even if you’re hoping for a simple divorce, you can still benefit significantly from consulting an attorney who specializes in divorce law. A lawyer can be objective, advising you of your rights, obligations and options and walking you through issues surrounding alimony, child custody and a divorce settlement. During this emotional period, an attorney will be able to help you focus on critical details regarding your divorce finances.
Estimate what you and your spouse are worth
The court may require a list of all marital assets and liabilities you and your spouse have jointly and separately. You should:
List all financial accounts and assets the two of you have, either individually or jointly. That includes stocks, bonds, real estate, mutual funds and workplace retirement plans.
Do an inventory of household possessions, including vehicles, appliances, electronic equipment and furniture.
Once you’ve accounted for all assets, list each of them under one of three categories:
1. Your pre-marital assets (things you brought into the marriage). 2. Your spouse’s belongings. 3. Marital property, or property acquired during the marriage.
The court will decide how to “equitably” divide marital property. Pennsylvania laws does not automatically define “equitably” as “equally.” The court and applicable law will also determine the ownership and division of all property and the responsibility for debt incurred during the marriage.
Itemize your liabilities — debts like mortgages, home equity loans, car loans, credit card balances, etc. Essentially anything else you and your spouse owe money for. List liabilities as yours, your spouse’s, or joint.
As an aside, if your marriage is in trouble, from this point on, it might be a good idea to postpone new and large purchases as well as the assumption of any new debt.
Review your Income and cash flow
After divorce, you’ll be a single person and maybe even a single parent. Financially, things will be much different from the way they’ve been, so it’s important to estimate your cash flow after the divorce, so you can plan for your new financial reality. You should also try to forecast future income to enable the court to determine child custody and alimony payments.
Give serious thought to creating a post-divorce budget as a tool for managing your money going forward. A budget can help you determine how you will need to scale back your lifestyle.
A budget can also help you focus on the income side of your cash flow. For example, you might realize that after the divorce, you will need to find a higher-paying job, or go to work if you’re not currently employed. You may even decide to go back to school as a way of enhancing your future income potential.
Review your insurance
Make sure you will have adequate health, disability, and life insurance coverage after a divorce. If you’re currently covered by your spouse’s employer-provided health plan, you can usually keep existing coverage for at least 36 months after a divorce under the Consolidated Omnibus Reconciliation Act (COBRA). You will have to pay premiums for COBRA coverage, and the premiums will probably be much more expensive, so you need to account for them in your post-divorce budget.
If you’re employed but don’t currently use your own employer-sponsored health plan, consider signing up for it. A group policy at work is typically much cheaper than an individual policy purchased on your own. Employers typically do not permit you to sign up for health insurance mid-year, but if you’ve experienced a major life event like a divorce, it may be possible.
After a divorce settlement, remember to review and, if necessary, change beneficiary designations on your life insurance policies and retirement/investment accounts, as permitted by court order. Definitely discuss your situation with a financial advisor
Your attorney may be able to provide limited guidance on financial issues. However, for broader assistance with the financial aspects of a divorce settlement, consider consulting with a financial advisor. He or she will also be able to guide you through longer-term financial planning, which might address issues like debt reduction, education funding, retirement planning and estate planning.