Divorce is inherently expensive, even if you get free divorce advice, minimize your legal costs and amicably agree upon all terms of the divorce. Unless one of you has a substantial new income source, the impact of now financially supporting two households instead of one will require a tighter budget and some lifestyle changes. However, there are multiple financial mistakes that people make during a divorce (or legal separation) which can damage their finances for many years to come. I will summarize these common mistakes in a few articles, beginning with the mistakes associated with the tax implications of different divorce settlements.
Failure to Consider the Tax Implications of your Divorce Finances
1. Trading or Cashing-In Investments
Be careful when trading between categories of assets, as some may be post-tax (such as a Roth IRA or equity in a home) while others may be pre-tax (such as a 401(k) or stocks), and therefore not equal dollar for dollar in a settlement proposal. To compare relative values, take into account both the tax impacts and the expenses required for turning the investment into cash.
Capital gains taxes from cashing in marital assets such as mutual funds, stocks, stock options, and gold coins can have a significant impact on your taxes. Even if you don’t plan to sell or cash-in the asset for several years, by assessing its’ current tax-adjusted value you can ensure you are making an informed decision when dividing your marital assets.
2. Divorce Finances from Real Estate Capital Gains
Depending on how you establish the terms of a buyout or division of the marital home, and the degree to which your home has increased in value, you may be exposing yourself to a large capital gains tax upon selling the home. If you can imagine selling the home at some point in your life, you may be the solely responsible for this tax burden.
The capital gains taxes on investment real estate (such as a rental house) may be even larger than you think. This is especially true if the original basis from a less valuable prior-owned property was rolled into the current property. Properties having equal value (equity) at first glance may have considerably different values when considering the capital gains tax implications.
3. Real Estate Tax Benefits
If it is worthwhile for one of you to itemize your tax deductions, then the deduction for home mortgage interest and property taxes can be a valuable benefit that you don’t want to ignore. If you are co-owning the home for a period of time post-divorce, how will you share these deductions? If you get divorced in October, and thus will file taxes separately for the current year, how will you share the value of these deductions from January to October? Make sure your divorce settlement agreement captures this benefit.
4. Retirement Account Division
If done correctly, the transfer of a portion of a retirement account to a spouse as part of a divorce settlement is one of the few times you can avoid the 10% penalty tax for a distribution prior to age 59 ½. For certain types of retirement accounts, including most Pensions and 401(k) accounts, this needs to be done with a separate court order called a QDRO (Qualified Domestic Relations Order), which will result in the receiving spouse having a similar type retirement account with the same early distribution rules.
The manner in which you divide these retirement accounts can substantially impact your divorce finances. The spouse who receives the distribution of a “qualified plan” such as a 401(k) may wish to cash out part of the distribution, and they can avoid the 10% penalty (if done correctly as part of the divorce process) but they will still pay income taxes: The distribution will be subject to an automatic 20% withholding at the time of distribution, and that extra income may bump the receiving spouse into a higher tax bracket. If the division of your retirement account is not done correctly by a knowledgeable professional, you may end up paying the 10% early withdrawal penalty and getting taxed on the division.
5. Filing Status and Dependency Exemption
There are a host of other, smaller mistakes that divorcing parents make that can affect their tax rates. For example, if parents have in their agreement that they are equally sharing parenting time of their two children, then neither parent would technically have the benefit of filing as “Head of Household,” a beneficial filing status which requires you to have a dependent greater than 50% of time. Instead, your settlement agreement should state that each of you has one of the children an extra day per year, or if you have one child, you may set it up to alternate who is qualified to use the “Head of Household” filing status.
The child dependency exemption is no longer valuable to most people since the new tax code beginning January, 2019 has a much higher standard deduction. However, determining who can file with the child as a dependent may affect your ability to claim other child-related credits and deductions, including the child tax credit, childcare tax credit, and credits for qualifying college expenses.
For low income households, the dependency exemption might be important to qualify for earned income credit and a host of social services, including State-sponsored health insurance. To protect yourself regarding any of the subjects in this section, it is highly advised to consult with a tax specialist for expert financial divorce advice before agreeing to any settlement proposal.