If you are in the process of divorce or if your divorce was final sometime this tax year or prior, you are probably unsure about the impact of divorce on your taxes. In fact, I seem to get the same questions every year around January, when it is too late to do any tax planning for the previous tax year. This blog was written to help you avoid the “coulda, shoulda, wouldas” as you prepare for some transitional tax years.
How do you know what your tax status will be this year?
If your divorce is final before midnight on December 31, you do not have the option of filing as a married taxpayer for 2022. That is true, even if you were married for the majority of the year. Your options are to file as a single taxpayer or as the more favorable head of the household. Head of Household status provides lower tax brackets and a higher standard deduction.
We often run an analysis for clients to help them determine if it is worthwhile to hold off on finalizing the divorce until January in order to be able to file as Married or Joint for the previous tax year. In some cases, this can save thousands of dollars in taxes for one or both clients. If you are splitting any refund or amount owed, this can be a financial win for both!
If you have minor children and you are unmarried on December 31, 2022, how do you determine if you should file Single or Head of Household?
According to the IRS, in order to claim Head of Household, you must have a qualifying child or dependent, and you must be the custodial parent. The IRS defines a custodial parent as the one who has more than 50% of the overnight visits (more than 182) with their minor child. Click here for IRS Rules on Claiming Head of Household. A common mistake among clients is that they think they can claim Head of Household simply because their Judgment of Divorce awards them the dependency exemption for their child. This actually is not enough. In fact, it is common to see parenting arrangements that are 50/50, with a very clear delineation in the agreement that each client will have exactly 182.5 overnights. This leaves both parents in a position of being unable to claim Head of Household.
What is the solution? If your divorce is not final, ask your attorney for guidance. Perhaps you and your spouse can trade off so that one year you have 183 overnights and the next year they do. If there are multiple children, another possible solution is crafting a parenting arrangement so one parent has 183 overnights with one child and the other parent has 183 with the other. As always, consult with a qualified accountant or tax specialist for advice on your specific situation.
Is there anything you can do to prepare for changes in your tax status?
One often overlooked, post-divorce task (remember that long list your financial advisor and/or attorney gave you when the divorce was final?) is confirming that your payroll withholdings are in line with your new filing status. For example, let us say that you were married through September but had never changed your tax status on your W-4 with your employer. Claiming that you are married with two exemptions might have made sense in the past, but if you are unmarried on December 31, that may not be sufficient. Your payroll withholdings might not be in sync with the transition.
At Pearl Planning, we do not want our clients to have an unpleasant surprise of a big tax bill in April. Therefore, we highly encourage our divorced clients to get a qualified accountant’s opinion on their estimated tax bill for the year as soon as the divorce is final. Once we have that information, we can strategize with the client and accountant on the best way to address any potential shortfall in taxes that may be on the horizon and make sure clients withholdings are appropriate going forward.
What counts as taxable income on your tax return?
Clients are often concerned that they will have to report assets received pursuant to their divorce settlement as taxable income. For example, suppose Jane receives $150,000 from her husband’s 401k via a Qualified Domestic Relations Order (QDRO). Does that count as taxable income? As long as Jane rolls over the entire $150,000 into an IRA account in her own name, it is not treated as reportable income. Neither is any asset transferred between spouses pursuant to their written divorce decree as long as it is within six years of the date of divorce. However, if Jane had decided to take a partial or full distribution from the 401k before rolling it over into an IRA in her name, that portion would be treated as taxable income to her at her highest marginal tax bracket.
Thanks to an exception in the tax code for QDRO distributions (IRS Code 72t2c), the 10% penalty that is usually assessed on premature (prior to age 59 ½) distributions is waived. As far as timing goes, I often recommend that clients consider whether it is in their best financial interest to take a distribution in the current tax year or wait until the next. These are conversations we often have with clients and their accountants in November and December.
Remember that knowledge is power. When it comes to your financial well being, it is better to be prepared than surprised. At Pearl Planning, we believe that financial planning is more than just asset management. We incorporate tax planning, retirement planning, estate planning, insurance planning and budgeting for all of our clients. If you have questions on how you can plan for your post-divorce tax years, Pearl Planning is here to help steer you in the right direction.
Investment advisory services offered by Pearl Planning, a DBA of Stephens Consulting LLC., an SEC registered investment adviser. Please remember that past performance may not be indicative of future results. Pearl Planning does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results.
Links are being provided for information purposes only. Pearl Planning is not affiliated with and does not endorse, authorize, or sponsor any of the listed websites or their respective sponsors. Pearl Planning is not responsible for the content of any website or the collection or use of information regarding any website’s users and/or members.
Pearl Planning cannot guarantee that the information herein is accurate, complete, or timely. Pearl Planning makes no warranties with regard to such information or results obtained by its use and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Pearl Planning, or any non-investment related content, made reference to directly or indirectly in this presentation will be profitable, equal any corresponding indicated historical performance level(s}, be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or a substitute for, personalized investment advice from Pearl Planning. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.
Diversification and asset allocation do not ensure a profit or guarantee against loss. Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal. Pearl Planning does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. We cannot guarantee that the information herein is accurate, complete, or timely. We make no warranties with regard to such information or results obtained by its use, and disclaim any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
If you are a Pearl Planning client, please remember to contact Pearl Planning, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, odd, or to modify any reasonable restrictions to our investment advisory services. Pearl Planning shall continue to rely on the accuracy of information that you have provided. Please Note: IF you are a Pearl Planning client, please advise us if you have not been receiving account statements (at least quarterly) from the account custodian. A copy of Pearl Planning’s current written disclosure Brochure discussing our advisory services and fees is available upon request or at www.pearlplan.com.
Jacki Roessler, Certified Divorce Financial Analyst® at Pearl Planning. Reach out for a call today at 248.875.4985. Schedule an Initial Consult Now.
600 S Adams Road, Suite 300 Birmingham, MI 48009