Navigating Divorce and Taxes: Key Insights for Protecting Your Finances

When people think about taxes in the context of divorce, one of the questions that often comes up is, 'What happens when I transfer assets from my name to my spouse's name as part of the divorce?' Generally speaking, the tax code takes divorce into account and has set up mechanisms to allow property to transfer without triggering major tax bills or penalties.

For example, if I'm getting divorced and part of my 401(k) is going to my spouse, normally, if you take an early withdrawal from your 401(k), you'd pay taxes and possibly penalties. But in a divorce, if you have a court order that specifies asset transfer as part of the settlement, those taxes and penalties can be avoided. As long as you work with an experienced and knowledgeable divorce attorney and likely involve your CPA in some parts of the process, you can transfer money in a way that doesn’t trigger tax penalties or payments related to implementing the court's divorce decree.

There’s also a lot of confusion around how alimony is taxed or not taxed, which is understandable because the rules recently changed. It used to be that if I paid alimony to my former spouse, I would get a tax deduction, and my former spouse would pay income tax on the alimony received. That rule still applies if your divorce was finalized when that was the default. However, under current rules, if I were to get divorced now and pay alimony, I would pay income tax on the money I earn, which I'm using for alimony, but my spouse wouldn’t pay income tax on that amount. This change makes alimony tax-neutral: I don’t get a deduction, and my spouse doesn’t pay income tax on it.

Now, if you had a divorce decree under the old rules and you’re seeking to modify it, you actually have some options. The tax treatment of modified alimony depends on what both parties agree to or what the court orders in terms of future taxation.

Another thing to consider with taxes and divorce is the timing of the filing, especially toward the end of the year. Your tax status for the entire year is based on your marital status on December 31st. So, if we’re close to finalizing your divorce in the fourth quarter, we’ll often recommend consulting with your CPA to determine whether it’s more advantageous for you to file as married, single, head of household, or another status. In many cases, it might make more sense to stay married through December 31st, which could provide a tax advantage. If that’s the case, we’ll discuss it with you and let you decide if you’re comfortable waiting until the new year to finalize the divorce, or if there’s a reason to proceed within the current tax year. Either way, understanding the tax implications of whether your divorce finalizes before or after December 31st is important, so you can make an informed decision.

Financial considerations in divorce are significant, and understanding how the entire process will be taxed is crucial. Working with a legal team that can perform a deep financial dive and collaborate with your CPA can help ensure that tax implications are carefully weighed. If you’re interested in understanding the tax aspects of a potential divorce in your situation, please give us a call.