When you are deciding on a settlement agreement with your soon to be ex-spouse, you need to consider the tax implications involved. There is a good article at DivorceNet which lists tax mistakes people make during the process of a divorce and contemplating a settlement agreement. These mistake tax tips are
- Not Looking at After-Tax Cash Flow When Analyzing the Workability of a Settlement Proposal. Look at the number of lines on your tax return that change as a result of divorce:
- Your filing status changes from married joint to head of household (if you have at least one child living with you) or single.
- The number of personal deductions will be reduced by at least one – your ex-spouse (more if you agree to split deductions for dependents).
- Your income without your ex-spouse may put you in lower bracket and you will be taxed at a different rate.
- Itemized deductions such as state income taxes, real estate taxes, mortgage interest, charitable contributions, and non-reimbursed employee business expenses may affect your return differently.
- Alimony is taxable and you are required to pay quarterly estimated taxes on it.
- The effects of AMT (alternate minimum tax) may not be changed without your spouse’s income and deductions.
- Failing to Negotiate Dependency Deductions. In 2005, the exemption amount for each dependent is $3200. In a divorce or separation, the custodial parent specified in the agreement is entitled to the exemptions or without an agreement, the parent with physical custody gets the exemptions. The lower income parent can sign over the exemption to the higher income parent using IRS form 8332 resulting in greater tax savings to the higher income parent. For example a $3200 exemption for a person in the 31% bracket would save over $1000 while a person in the 15% bracket would save under $500. The value of exemptions starts to phase out for income above $145,950 for a person filing as single, so the exemption may only be effective for a lower earning spouse. Don’t forget to factor in the child tax credit ($1,000 for each child under age 17) and dependent care credits for up to 2 children under 13 ($960 or more).
- Not Using IRS Code Section 72t(2)c to Get Distributions from Qualified Plans. More often then not, couples in the process of a divorce have severe cash flow problems. Income stays the same, but expenses increase dramatically because there are two households to support. Changing or downsizing one or both parties' lifestyles often requires a cash infusion to purchase, set up, or carry a second residence. Section 72t(2)c allows the alternate payee (the spouse who is not the employee) to take distributions from a qualified plan (not an IRA) without paying the 10% early distribution penalty even if they are younger then 59 ½. The distribution is still subject to income tax. If the funds are first rolled over into an IRA then the preferred distribution rules no longer apply.
- Not Following the Rules for Alimony. Alimony is deductible to the payor and taxable to the payee. Where alimony is given there is usually a significant disparity in incomes. Alimony results in tax savings since the higher income individual is able to deduct payments at a higher tax rate while the ex-spouse pays taxes at a lower tax rate. Section 71 of the Internal Revenue Code defines certain rules for payments to be considered alimony. If these conditions are not met then the tax benefits of alimony could be revoked by the IRS.
- Alimony payments must be in cash, to your ex-spouse, designated in a divorce or separation agreement, and you must live in separate residences
- Payments must terminate on death of the recipient; alimony cannot end on dates corresponding to dependents 18th or 21st birthdays
- Alimony cannot be front loaded over the first three years (much larger amounts paid in the 1st year compared to the 2nd or 3rd year).
- Disregarding the Impact of Taxes on Assets in a Divorce Settlement. The marital assets you keep after the tax man gets his share is the real bottom line. Say your spouse handles all the investments and offers to split them 50/50. Would you rather have cash in the bank, an IRA, or the Microsoft stock you bought in the early 1990s? Each of these assets is taxed at a different rate. Avoid assets that are unattractive from a tax point of view such as low-basis stocks (those that have increased dramatically since you bought them), partnerships where depreciation might be recaptured, or retirement accounts where you have to pay tax on the money you get. Look at the value of assets you will receive on an after-tax basis. Then decide if the deal is fair.
- Failing to Take Advantage of the Full $500,000 Home Exclusion. Married couples are allowed up to $500,000 in profits tax free from the sale of their principal residence. Formerly, a spouse who moved out as a result of divorce lost his $250,000 deduction because it was no longer his principal residence, but thanks to a change in the tax law an ex-spouse can now retain that exclusion. To qualify, the spouse who moved out must remain an owner and the divorce or separation agreement must grant him use of the home. The ex-spouse must have lived in the home for two years at any time prior to the sale. If these rules are not followed, the spouse selling the residence will only be able deduct a $250,000 gain and will have to pay tax on the second $250,000. Capital gains tax on $250,000 is $37,500 and state income taxes may also apply. If a spouse who is the sole owner remarries, the new spouse must live in the house for two years to qualify for the full $500,000 exclusion.
- Not Writing Off the Cost of Your Divorce. The portion of the cost of your divorce which relates to tax and financial advice is deductible on Schedule A of form 1040. To substantiate this deduction you should obtain a statement from your attorney or mediator delineating the cost of legal services and the amount attributable to tax and financial advice. Normally the deductible portion of your divorce runs from 1/3 to ½ of the total cost. In order to deduct legal fees, you must be filing Schedule A (Itemized Deductions) and your deductible divorce fees must be greater than 2% of your income.
Ask your attorney about these mistake tips. If your attorney isn't a tax attorney, he or she can consult with a tax expert and obtain the answers or you can consult with your own accountant to determine specifically how the terms of the proposed settlement agreement will affect you.
Source: DivorceNet's Seven Tax Mistakes in Divorce by Lee Slater, Divorce Financial Planner