Tax Consequences in Divorce and How to Prepare for Them

Tax Professionals' Resource
January 15, 2013 — 1,110 views  
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When going through a divorce, it is necessary for both the spouses to reach an agreement on different financial arrangements. Doing so will help to avoid tax consequences and save a lot of expenses that can occur with the passing time.

There are many major tax pitfalls that can occur in a divorce settlement. Accounting professionals, who handle the finances involved in a divorce case, should be able to recognize these divorce taxation consequences and take the proper steps to tackle them, before they become a problem.

Given below are the major tax consequences, which can occur in a divorce, and the tips to prepare for them.

Tax Filing Status

One of the major areas of concern that one should be aware of while undergoing a divorce is the yearly tax filing status. If the divorce is not finalized yet, then you can file your returns as either “Married Filing Separately” or “Married Filing Jointly”. Filing in a joint manner will make both the spouses responsible for payment of taxes, and due to this tax advantage, many couples file their taxes in a joint manner. But, you will be considered 100 percent responsible for the remaining payments, if your spouse fails to pay his/her part of the taxes. To avoid this issue, both parties should reach on a mutual agreement on the tax filing status well before hand.

Disputes in Division of Assets

During a divorce, a major dispute can arise in the case of division of financial assets between spouses and the taxes payable in this regard. If asset transfer is done after the divorce is legalized, then a huge amount of money will have to be spent on taxes. Asset transfer between married couples is not taxable. So, before finalizing the divorce, an agreement should be reached regarding how much money each party shall receive and transfer of assets should be accordingly done so as to prevent further consequences regarding divorce taxation.

The above said rule is not applicable while transferring the retirement account assets from one spouse to the other. To avoid problems in this regard, it is necessary for the details of the retirement account transfer to be separately mentioned in the divorce settlement. This will allow the establishment of a qualified retirement account for the recipient spouse so that money can be transferred directly into a new account without taxation issues for the recipient or the donor.

Taxation Involved in Alimony

Alimony is generally non-taxable for the spouse making the payment and is taxable for the recipient. If the divorce agreement states that the payment of alimony is to end upon the event of the recipient’s death, then it is considered taxable. If the divorce agreement states that the payment should continue even after the death of the recipient, then it is not considered taxable. This can lead to differences regarding alimony settlement, which can further lead to tax consequences in the future.

To avoid these divorce taxation issues, one can structure the alimony settlement as a tax-free one. This can be done by demanding a lump-sum amount from the spouse who is paying it. If he/she is unable to make a single payment, then an installment plan can be negotiated in such a way that the recipient receives the money in a tax-free manner over time.

Tax Professionals' Resource