During your divorce, you will likely have to make many tax decisions. It may not even be obvious that taxes are a factor or something to consider when considering your options. But, there are reasons why there is a whole tax profession and over 60,000 pages of tax code – taxes are expensive and confusing!

It is unequivocally important to understand the basics so that you can make informed decisions and optimize your settlement.

That said, don’t feel like you’re on an island. Many professionals can guide you every step of the way. Like having a lawyer to help you through your divorce, financial planners and accountants should be part of your empowerment team to ensure you maximize your post-divorce assets and cash flow on an after-tax basis.

Here are some of the most common initial questions, consider this Divorce Taxes 101.

Are taxes due on a divorce settlement?

The transfer of assets between spouses due to a divorce generally does not have any tax consequences.

Should I file jointly or separately?

Your marital status on December 31^st determines your filing status that year. Couples sometimes wait until January to finalize the divorce to reduce taxes owed for the previous year. It works whether you produce jointly or are married separately for that year.

What is the status of head of household?

To qualify for head of household status, you must be legally single, pay more than half of household expenses, and have either a qualified dependent living with you for at least half the year, or a relative for whom you pay more than half of his living expenses.

What are the tax differences to consider when splitting qualified/retirement 401(k) and IRA accounts versus non-qualified/after-tax pooled or individual assets?

Ordinary income rate apply when funds are withdrawn from a qualified/retirement plan. Keep in mind that there is likely an additional 10% penalty if the funds are withdrawn while the person is under 59.5.

Capital gains rate apply to non-qualified/after-tax account withdrawals, which are generally lower than ordinary income rates. Additionally, when selling positions to raise funds, one is only taxed on the recognized gain, not on the full withdrawal, as is the case with distributions from a qualified account.

It is essential to understand that dividends and interest earned in an investment account, as well as capital gains distributions, are taxable in the year they are received. They are not taxed until they are withdrawn from tax-deferred accounts.

When deciding to split an investment account, pay attention to the cost base (purchase price) of the securities.

Pro Tip: Make sure the settlement agreement specifies who should receive the tax refunds, loss carryforwards, or tax debts.

Bonus Pro Tip: During the last year of filing a joint return, work with a CPA to determine how much each spouse owes based on their respective incomes. Splitting the taxes due in two may not be reasonable. Situations where this might apply are a two-earner family or where the spouses live apart and support themselves. It is important for the CPA to consider the distribution of tax refunds, penalties, deductions and the claim of dependents.

Types of accounts

Not all account types are equal when dividing assets between spouses. Remember when I mentioned that taxes have a role, even when it’s not apparent?

Here is an example. Let’s say you and your spouse have $1 million in net worth, $500,000 in a traditional IRA, and $500,000 in a taxable account. Simply giving one spouse the pension assets and the other the taxable assets would not be considered an equitable split because of the difference in tax treatment at the time of withdrawal. Depending on each spouse’s income, the IRA may have ~$100,000 in taxes built in and only be worth ~$400,000 after tax, while the taxable account may only have ~$20,000 in taxes owed and worth ~$480,000 after tax.

The point to remember is that it is generally more desirable to receive taxable assets in a divorce settlement compared to a traditional IRA. Roth assets are the most beneficial to receive due to the tax-free treatment of withdrawals.

Taxable accounts (also called brokerage accounts, after-tax accounts, or non-qualified accounts) are funded with dollars that have already been subject to income tax. The growth of these dollars is taxed at a preferential rate capital gains rate of 0%, 15% or 20%depending on your situation.

Tax-deferred accounts include traditional IRAs, qualified retirement accounts, pensions, 401ks, 403bs, deferred compensation plans, SEPs, Keoghs and simple plans. These accounts receive a tax deduction when the money is paid out and are taxed as ordinary income rate of 10%, 12%, 22%, 24%, 32%, 35% or 37% when the money is withdrawn. These accounts are generally subject to an additional 10% tax penalty if removed before age 59.5, although there are exceptions to this.

Roth IRAs or Roth 401ks do not qualify for a tax deduction when money is contributed but are not taxed when money is withdrawn (assuming the withdrawal takes place after 5 years and the account holder is over 59.5). These are the “best” accounts receivable from a tax perspective because all taxes have been prepaid and any future growth or withdrawals are free from Uncle Sam’s grasp.

Divorce-Specific Tax Considerations

If you’re a little overwhelmed with reading about taxes, take a deep breath and trust that you’ll make informed decisions with the help of your empowerment team. Below are the essential concepts to understand about taxes and divorce. You are probably familiar with many of the following concepts.

Married declaring spouse, Married declaring separated, Single or Head of family are all examples of filing status. Spouses file their returns based on their marital status on December 31 and are both responsible for anything reported or unreported on a joint return, regardless of who earned the income.

A Qualified Domestic Relations Ordinance (QDRO) is a legal document that directs the administrator of a qualifying pension plan to distribute a portion of the pension benefits to the spouse so that the transfer is not taxable. QDROs are exempt from the 10% penalty on outs before 59 ½. IRAs do not require a QDRO and are not exempt from the 10% penalty on early withdrawals.

Tax arbitration is smart tax planning that maximizes the after-tax value of family assets by taking advantage of the fact that one spouse has a lower tax rate than the other spouse.

custodial parent The IRS defines the custodial parent as the parent who has the child for more nights. If the nights are equal, the parent with the highest income is the custodial parent.

Form 8332 is the IRS form that releases the exemption request for a child by the custodial parent so that the non-custodial parent can request an exemption for the child. Although personal exemptions were removed in the Tax Cuts and Jobs Act 2017, it is still beneficial to claim the Child Tax Credit for minor children.

Basic tax terms and concepts

In a vast sea of ​​tax jargon, it helps to have a basic understanding of some of the terms you’re likely to hear. This is the vocabulary you need to be familiar with when discussing taxes during your divorce.

• Marginal tax rate: This is the tax rate you would pay on an additional dollar of taxable income. Typically, this is your highest tax bracket.
• Ordinary income: Income from the following sources: W-2 income, interest, pension income, IRA/401k withdrawals. These are taxed at the higher rates of 10%, 12%, 22%, 24%, 32%, 35% or 37%.
• Long-term capital gains: The tax that applies to an increase on investments held for more than 12 months. In 2022, the long-term capital gains tax rates are 0%, 15% or 20%. These are usually lower than your earned income rates.
• Short-term capital gains: This is a tax that applies to an increase on investments held for less than 12 months and is taxed at the ordinary income rate.
• Capital losses: The loss incurred when an investment has fallen in value from its original purchase price. Capital losses can be long-term or short-term depending on whether they have been held for more or less than 12 months.
• Capital losses offset capital gains: This means that you can use any losses you have on an investment to offset gains. If you don’t use all of the losses in a given year, you can carry those losses forward and use them in future tax years – it’s a valuable asset to be negotiated, if available.
• Income earned: W-2 earnings and 1099 self-employment earnings are subject to Social Security tax. Earned income is required to make IRA/401k/403b/Roth IRA/Roth 401k contributions.
• Standard tax deduction: A predefined amount (based on the status of the return) and corresponds to the part of the income not subject to tax which can be used to reduce your tax bill. Taxpayers can either use the standard deduction or itemize their deductions.
• Detailed tax deduction: Varies by taxpayer and includes mortgage interest, medical expenses and charitable donations. The amount of property taxes and state income taxes combined is limited to $10,000 per year.
• Mortgage interest deduction: Deduction of mortgage interest on the first $750,000 of a mortgage loan used to acquire or improve a new house. Interest on home loans not used to buy or build a house is no longer deductible.
• Estimated tax payments: The IRS requires quarterly tax payments on earned income that is not withheld at source or on investment income.

As taxes can become complicated during a divorce, it is very important to seek the help of professionals who know both the legal aspects of divorce and the tax nuances. Email our firm’s Divorce Practice Group at [email protected] for more information and to obtain a copy of our 2022 tax chart.

What is taxing you in your divorce?