Divorce and Taxes

Divorce is always a challenging time for all parties involved and is an unfortunate reality for many people. With that said, we want to make sure that we do not get caught with unforeseen and unwanted income tax effects.

Video Transcript - Divorce and Taxes

The first thing I want to talk about are the new alimony rules under the tax cuts and Jobs Act of 2018. Prior to 12/31/2018 we could deduct alimony that we paid to a former spouse and that former spouse would have to include that alimony in their gross income, then we received a deduction, and they had to pay tax on it. However, those rules have changed; effective 12/31/2018 any divorce originating after that time, alimony is no longer deductible to the payor and is no longer considered income to the recipient. This is going to have a huge impact on people. Now do not be alarmed if your divorce was already settled prior to that and you have already been paying alimony, you are okay, you are grandfathered in under this new law. But any divorce that originated after that point in time, alimony is no longer deductible to the person paying it, or the income of the person receiving it. This is important because it is going to have a major effect on the settlement agreement that you negotiated, or that your lawyer negotiates on your behalf in that divorce. Typically we have been a little more likely to want to pay alimony because we get a deduction for it. But that is not going to be the case anymore; therefore, you should consider when you are crafting that divorce settlement agreement. If your attorney does not bring it up to you, mention it to them, because they should know that it is very important. As always consult your CPA in any major life changes, especially a divorce. Talk to your CPA first and foremost that way they will be able to give you the current rules and tell you how you are going to be affected by them.

The next thing I would like to talk about is, what happens to a qualified retirement plan in a divorce? These days many of us have 401ks and other qualified retirement accounts. What happens to them when we get divorced? You always hear about them being divided, you hear about them being marital property if that money was contributed or grew, or deferred while you were married. Generally that money becomes part of the marital estate and becomes marital property. Keep in mind, different states have different rules on how property is divided. Some states are community property states where you go down the middle 50/50, other states look at the lifestyle (there can be an unbalanced settlement depending on the lifestyle). But that is not the point. The point is, in a divorce you will likely have what is called a QDRO; a qualified domestic relations order. That is where the courts say that a 401k or other qualified account, has to be divided between two people--between the spouse who contributed the money and the spouse receiving the money. Now the fact of having a QDRO does not create a taxable event to you because the IRS has a specific exclusion for QDROs. It does not trigger a taxable event whereby, you are taking money out of your qualified account and you may have a 10% penalty and you have to pay income tax on that money; rather the QDRO is an exception to that rule.

But what I have seen happen in the past, in a divorce where a lot wealth is in qualified plan and a QDRO takes place and a spouse suddenly gets part of a 401k account or some other qualified plan, they begin taking money out of that plan to live, to pay bills, to pay their attorneys, and unbeknownst to them they have a 10% penalty and have to pay income tax on the money they took out. Even though the money came from your former spouse, you are the one that took it out, and so you are the one to pay the tax. It is unfortunate that a lot of times this catches people by surprise. So please be aware, especially in a situation with a QDRO, you need to talk to your CPA. They can tell you what will happen if you take money out of that account, they can tell you how and when that can be done, and they can tell you what the consequences may be.

Another point to make, typically a husband and wife, have the same CPA. When they get divorced a lot of times the CPA does not continue to do business with both spouses because of a conflict of interest. In our firm confidentiality paramount and we will only continue to work with both the husband and wife if they are both in agreement that it is okay. The point is, if you are the spouse who does not retain that CPA you need to go find another CPA immediately. For help on this refer to my other video about how to select a CPA.

Finally, the last thing and this is an easy one but a lot of people miss it. Check your allowances at work, check your withholding. For those of you that are working and getting a W-2, every year you probably fill out a W-4 form where you tell your employer and in turn the federal government, how much federal income tax to withhold on your behalf. At the end of the year that withholding is reflected when you file your income taxes.

What you do not want to have happen is that you file as married filing jointly for part of the year, you get divorced, you do not change that withholding allowance, yet you continue withholding at that married filing joint rate. The married filing jointly is less than the single rate, thus you get to the end the year and you are hit with the unwelcome surprise that you now owe more taxes because not enough federal income tax was taken out of your paycheck. So be certain that upon receiving a divorce you sit down with your CPA and you ask them the following questions: How do I update my W-4? How much you should I withholding from my paycheck? How much money should I be paying in? That way at the end of the year there are no surprises.

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