Divorce can bring many changes to a Net Worth statement, as assets are allocated between the ex-spouses. In addition, consideration should be given to tax-related items, like filing status, deductions, and credits.
Qualified Retirement Plan Accounts
A Marital Settlement Agreement may require the bifurcation of retirement plan assets, such as a profit-sharing 401(k) or a defined benefit pension plan or a Traditional IRA. The transfer of employer retirement assets to an ex-spouse often requires a Qualified Domestic Relations Order (QDRO) whereas the transfer of an IRA or Roth IRA may not. Both types of transfers result in a tax-free transfer of assets.
Although the transfer may be tax-free, the tax treatment of the account remains the same. For example, changing ownership of a tax-deferred 401(k) from one spouse to another does not result in income tax, but the receiving spouse has taxable income when money is subsequently distributed from the 401(k).
Capital Assets
When a capital asset falls under the tax-free transfer rule, the spouse who receives the asset takes over its existing tax basis (for tax gain or loss purposes) as well as its existing holding period (for short-term or long-term holding period purposes).
Home Sale Exclusion
Generally, if certain conditions are met, gain on the sale of a primary residence may be excluded from taxable income up to a certain amount. For divorced spouses, it is important to consider the exclusion criteria when determining what to do with the marital home.
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Income Tax Filing Status
In general, a taxpayer’s filing status depends on the marital status on the last day of the year.
- If someone is unmarried, divorced, or legally separated according to state law on December 31st, that person must file as a Single person for that year.
- Certain married individuals, not legally separated or divorced, may be considered Single if they are living apart.
- A married couple, if not legally separated or divorced and not otherwise qualifying as Single, is not required to file jointly. Each spouse may elect Married Filing Separately. Click here for information on filing separately in a community property state.
Child Tax Credit
In general, the custodial parent is eligible to claim the Child Tax Credit. However, a different arrangement may be stipulated in the divorce decree. If the divorce decree is moot on tax matters, IRS Publication 504 provides guidelines to assist divorced or separated individuals.
For Purposes of The Child Tax credit and Credit for Other Dependents, a child will be treated as the qualifying child or relative of the noncustodial parent if all the following conditions apply:
- The parents are divorced, legally separated, separated under a written agreement, or lived apart at all times during the last 6 months of 2021 (whether or not they are or were married).
- The child received over half of his or her support for 2021 from the parents (and the rules on multiple support agreements don’t apply). Support of a child received from a parent’s spouse is treated as provided by the parent.
- The child is in custody of one or both parents for more than half of 2021.
- Either of the following applies:
- The custodial parent signs Form 8332 or a substantially similar statement that he or she won’t claim the child as a dependent for 2021, and the noncustodial parent includes a copy of the form or statement with his or her return. If the divorce decree or separation agreement went into effect after 1984 and before 2009, the noncustodial parent may be able to include certain pages from the decree or agreement instead of Form 8332.
- A pre-1985 decree of divorce or separate maintenance or written separation agreement between the parents provides that the noncustodial parent can claim the child as a dependent, and the noncustodial parent provides at least $600 for support of the child during 2021.
Other Child-Related Tax Matters
Meeting the criteria for the Child Tax Credit does NOT allow the noncustodial parent to claim:
- Head of Household filing status,
- The Credit for Child and Dependent Care Expenses,
- The exclusion for dependent care benefits,
- The Earned Income Credit, or
- The Health Coverage Tax Credit.
These credits are available to the “custodial parent”, defined by the IRS to be the parent with whom the child lived for the greater number of nights during the tax year. If the child was with each parent for an equal number of nights, the custodial parent is the parent with the higher adjusted gross income.