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Divorce can be quite a traumatic time for both parties involved.
Often the last thing anyone even considers is the actual tax implications of said divorce on each partner.
I thought this was a not often talked about subject matter in the financial blogosphere and hoped to rectify this.
Beth Logan, EA, a federally licensed tax practitioner who has authored the book, “Divorce and Taxes: After Tax Reform,” graciously offered to shed some light on the subject matter.
[Disclaimer: Besides the use of the book affiliate link (with no extra cost to you), Beth Logan and I have no financial relationship.]
We’ve all met that divorcing spouse that is so focused on the child custody that others things get missed.
We also know the vindictive spouse going through a divorce.
While these are the more extreme reactions to divorce, emotions play a large part in the divorce process and often to the detriment of the couple’s finances.
Case Example A:
Recently, I helped out with a divorce involving two children.
Each spouse was going to claim one child because that was only fair.
But what does this actually mean?
Well, in this case, a worse financial situation and not much more.
Kelly was fighting for more money.
Drew was fighting for more of the payments to be considered alimony.
This is because in divorces before 2019, the alimony is deductible on the tax return of the payer.
The custodial arrangement was already decided and Kelly would have the children about 60% of the time.
As a neutral third party, I looked at the situation.
Drew could not claim Head of Household because Drew did not have either child for 50% of the time.
Also, Drew’s income was too high to claim the child tax credit.
Therefore, there was no financial benefit in Drew claiming either child.
Instead, Kelly was able to claim both children, resulting in an additional $2,000 tax credit.
Because Kelly was getting the $2,000 tax credit, Drew could reasonably argue that payments to Kelly could be adjusted.
Case Example B:
When working with another divorcing spouse, there was a strong desire to split the assets equally.
Equally is not always equitably.
Chris was in a vindictive mode causing Terry to want the whole divorce to just end.
I showed that both would be better off dividing the assets based on after-tax value.
In their haste to end the process, they divided the assets essentially in half but leaving Chris with the house.
The problem with this couple was that Chris had no income.
Terry ended up selling stock causing a capital gains tax issue.
Chris, who could have sold the stock over a few years and paid no tax, ended up the with house.
Instead, Terry could have transfer the investment account to Chris.
Then Chris could sell the stock as money was needed.
The tax rate on the stock sale would be 0% or 15% instead of the 20% that Terry paid.
Additionally, if neither spouse was planning to keep the house, then it should have gone to Terry and other taxable assets to Chris.
Selling the house would have been a tax free event for either of them.
The other assets with taxable income would appear on Chris’s tax return which has lower taxable income and therefore, lower taxes.
Overall, the couple could have left the marriage with more money if good tax planning was followed.
The US and state governments received tens of thousands of dollars in taxes thanks to the couples emotional approach.
It is perfectly reasonable to have strong emotional reactions during a divorce, but they need to be compartmentalized.
To avoid financial pitfalls it is essential to set some time aside to be practical.
It may be valuable to have a neutral third party look at the financial situation and provide ways for both spouses to benefit using taxes strategies.
In the long run, having the strongest possible financial situation will allow both spouses to move forward in their respective lives and will help any children as well.
Beth Logan, EA
Author, Divorce and Taxes After Tax Reform
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Fascinating case studies. Thanks for sharing this Beth and Xrayvsn – I would not have predicted such drastic tax savings could be had with strategic division of assets. Could this herald the dawn of divorce policy statements? They can identify tax-friendly asset division if the relationship is amicable to tolerate it.
Yeah I never thought about it either (and honestly in my situation I couldn’t care if my ex got hit with taxes). But yeah if both parties are amicable, it makes a lot of sense to make divisions favor the parties rather than uncle Sam
Divorce would devastate me financially. I don’t anticipate it of course. And I’d expect an amicable 50/50 division of assets. But I would certainly have to go back to work or continue with a pretty modest retirement.
As it is, we’re very comfortable in early retirement. Even with three three teens. The financial impact of divorce would derail it all.
Thanks for stopping by Colleen. Glad you don’t see a divorce in your future because I agree it can certainly pull the financial rug out from under you. People who retire early may be only able to do so as a couple and may find themselves needing to work again post divorce. I am sure there are some unhappy couples in this situation that are trapped because of this dilemma
I have a friend going through a not so amicable divorce right now. I’ve tried talking to her about how the lawyers are the only ones that come out ahead in the situation they are in…gridlock…now I’ll have to find a way to bring up the tax man.
I’m sorry for your friend. Divorce is not fun even under the best of circumstances. When its adversarial (like mine was) it can be an utter nightmare. Yes lawyers are really the only ones who profit for in a contentious divorce (I wrote about my own nightmare where just my legal fees came to $300k: https://xrayvsn.com/2018/05/15/i-have-pretty-much-made-every-mistake-in-the-book-part-iii-2/
It’s sad but true that divorces can come with vindictive spouses who can’t see reason even if it can help them in the long run. All they want to hear is that they are getting their way even if there an even better way for everyone to be happy.
Divorces and taxes.. Two subjects that aren’t very pleasant to a lot of people out there.
I agree completely. I had a brutal divorce and my ex was super vindictive. Spent so much time in court and the only people that profited were the lawyers.