Recently a client decided to delay her divorce because she wanted the tax deduction for the children. She didn’t realize that alimony is taxable, so putting off the divorce ended up costing her. With tax season just around the corner, you need to be hyper-aware of what you should consider when filing your income tax returns, especially if you are separated or divorced. The three big ones are: filing status, tax deductions for children, and alimony and child support.
Your filing status is used to determine your filing requirements, standard deduction, eligibility for certain credits and your correct tax. You want to choose the one that results in the lowest amount of tax. In general, the tax rates get higher in this order, starting with the most advantageous:
-Married, filing jointly
-Single, head of household
-Married, filing separately
But there are things to consider—carefully—before you decide which way to go.
As far as the IRS is concerned, If you are separated but still legally married as of December 31 of the year in which you are filing, you are considered married and can file a joint return with your spouse. Is this a good idea? Keep in mind that if you file jointly, you could be liable for any problems related to the return. I have heard from countless women who say they didn’t know they were exposed to the liability of the joint return they signed. It is never a good idea to sign without fully understanding all of the information claimed.
If you aren’t sure of the information, hire an independent accountant and have them review any tax returns before you sign them. Worst case, if you find you have signed a return that creates a liability, you can try to invoke the “innocent spouse” principle that allows a spouse to escape liability, if they can prove their case. I don’t suggest this as a plan, but it may help if you find yourself in that position.
Since your filing status depends on your marital status as of December 31, if you were divorced by that date you would file as single taxpayer, regardless of whether or not you and your spouse lived together during any part of the year.
If you are still married on December 31, and if you and your spouse live together, and are not legally separated, you must file either married filing jointly, or separate returns. Married filing separately is usually the least cost-effective way to file taxes.
Single, Head of Household
You may qualify for Head of Household if you meet the following conditions:
-You were unmarried or considered unmarried on December 31.
-You paid more than half of the household costs for the year.
-You have a child or other qualifying person living with you for more than half the year.
Tax Deductions for Children
Most divorcing couples believe that they are entitled to take the exemptions for the children. I have seen divorces delayed due to people thinking they will lose the exemption if they divorce. Often times, when there are multiple children, spouses agree to split the exemptions. While the IRS assumes that the spouse who has custody of the children is entitled to the exemption, in fact the spouses are allowed to trade them back and forth freely, using IRS Form 8332.
Honestly, the spouse with the higher income should tax the deduction, otherwise, they are missing a chance to maximize tax savings. I know this idea makes the other spouse feel like they are missing out on a tax savings so I suggest consulting with an expert on tax in divorce who can calculate the value of the exemption(s) to each spouse. The one who can make better use of the exemption(s) should take all of them, and if appropriate, compensate the other spouse. As my mom always says, pick your battles—and this would not be the one that I would advise you to pick.
Alimony and Child Support
It is important to understand the following: child support is not a deduction for the paying parent nor taxable income to the receiving parent. Alimony is. When completing your lifestyle analysis, you should take into account (as an expense) the taxes that will be due on alimony, and budget to pay that expense quarterly. Otherwise, April 15 will come and you will be upset with the tax bill that may be handed to you. Believe me, I have clients who are prepared and still get upset! It is important to consider taxes when negotiating alimony. When possible, would it be better to take a larger marital asset distribution in lieu of alimony? Short answer—yes!
Taxes are not simple, and, as in all complicated issues, it will benefit you to consult your lawyer, certified divorce financial analyst (CDFA), or financial advisor for further details.