Your divorce will affect your income taxes in numerous ways. First, your filing status will change to reflect your marital status on the last day of the year for which you are filing your taxes, and you will avoid the “marriage penalty” which still afflicts married couples under our tax system. If you paid more than half the cost of keeping up your home, and it was your child’s main home for more than half the year, you most likely will file as Head of Household. Otherwise, you would most likely file as Single. For 2002, Head of Household status is projected to provide a standard deduction of $6900, as opposed to $4700 if you were filing Single. Thus, if you don’t have enough deductions (e.g. mortgage interest, real estate taxes, state income taxes) to itemize, you will get a larger deduction, and thus lower taxes, filing as Head of Household than filing as Single.
Second, whoever gets the dependency exemptions for your children will also affect your taxes. Each dependency exemption will probably be $3050 for 2003, which serves to lower your taxable income and thus your taxes. The higher your tax bracket, the more the exemption will lower your taxes. Generally, the parent with whom the child lives more than half the year will be entitled to the exemption, but the custodial parent may relinquish the exemption — on a year by year basis or on a permanent basis — to the non-custodial parent in exchange for other concessions. There are specific IRS requirements to be met if the exemption is to be transferred, so be sure to check with your tax advisor about this.
Perhaps the largest impact on your taxes will involve whether any support payments made by one spouse to the other are characterized as, and meet the requirements of, child support or alimony (otherwise known as spousal support or unallocated family maintenance). Child support is not deductible by the payer (i.e. it is paid with dollars taxed to the payer), and it is not taxable to the payee. Alimony, on the other hand, is deductible by the payer and taxable to the payee. This fact can provide many financial-planning opportunities during the divorce process, particularly when there is a large discrepancy between the parties’ income levels and marginal tax rates. It may, for example, be possible for the payer to pay a higher amount of support to the payee and still save money if the payments are taxable to the lower-income payee. There are, however, explicit and sometimes very complicated tax laws governing whether a support payment qualifies as alimony, and it is strongly advised to consult your tax advisor on this issue.
Transfers of property from one spouse to the other associated with the divorce are done without any immediate tax consequences, and the “tax basis” of the property remains unchanged. When the property is eventually sold, that tax basis, modified by any subsequent adjustments to it, is used to determine whether a taxable profit or a deductible loss has been realized. Therefore, it’s important that you know the tax basis of the property you are dividing up during settlement negotiations, so that you can avoid the situation of getting hit with a big tax bill by ending up with most of the assets bought long ago with big profits built-in.
Finally, what you do with retirement assets such as 401k plans or IRAs can have an enormous tax impact if handled incorrectly. If you cash in any of your own or your spouse’s retirement assets, you will owe income taxes on the amount you cash in. If you are under the age of 59 and don’t qualify for one of the exceptions, you will also owe a 10% penalty on those funds.
In general, you and your ex-spouse combined will pay less taxes after the divorce than before. However, it’s easy to make mistakes, and professional advice could help you avoid them and save money on taxes.
Marcia B. Kraus, CFP, CPA, CDFA, formally heads Divorce Financial Strategies, an independent firm in Naperville, IL. She provided advice for clients dealing with the financial issues in and after divorce.