Divorce often comes with emotional and financial challenges. Beyond dividing property and assets, couples need to understand how their settlement may impact taxes. Being informed about potential tax consequences can help avoid surprises when tax season arrives.
Division of assets and tax liability
When dividing marital assets, the transfer of property between spouses is typically tax-free if it occurs as part of the divorce settlement. However, selling shared property, such as a home, may result in capital gains taxes. Couples can usually exclude up to $500,000 of gains from selling a primary residence if they meet certain criteria, but after divorce, this exclusion often drops to $250,000 per person.
Taxable and non-taxable spousal support
Alimony, or spousal support, used to have significant tax implications. For divorces finalized before 2019, the recipient reports alimony as income, while the payer can deduct it. However, under current law, alimony is neither taxable to the recipient nor deductible for the payer if the divorce was finalized after December 31, 2018. This change can affect negotiations and the financial outcome for both parties.
Child-related tax considerations
Deciding who claims the children as dependents can have tax benefits. The parent who claims the child may qualify for valuable tax credits, such as the Child Tax Credit or the Earned Income Tax Credit. Generally, the custodial parent—who the child lives with for most of the year—has the right to claim these benefits unless they agree otherwise in writing.
Retirement accounts and tax penalties
Dividing retirement accounts, like 401(k)s or IRAs, can lead to penalties if not handled correctly. A qualified domestic relations order (QDRO) is necessary to avoid taxes and early withdrawal penalties when transferring funds. IRAs have different rules and may not require a QDRO, but specific procedures must still be followed to avoid unintended tax consequences.
Understanding the tax implications of a divorce settlement ensures smarter financial planning during a challenging time. Speaking with a qualified attorney or financial advisor can help navigate these complex issues effectively.