In 2024, the American Psychological Association (APA) estimated that 41% of first marriages were likely to end in divorce. Divorce can be a complex and emotionally taxing process, but understanding the financial implications is crucial, also. Many of the decisions made will impact long-term financial planning and still others have more immediate consequences that can affect income taxes.
Ideally, planning on how to divide assets should take place before divorce or separation. Particularly for those with significant assets, the tax issues associated with dissolution of the marital estate can be convoluted, complicating the process of arriving at a fair and equitable resolution. Ownership interests in a business, equity compensation payable to one of the parties, retirement accounts, and other assets should all be considered as a part of the pre-divorce negotiations. Understanding the financial and tax implications of assets like these is critical in the decision process, and having reliable, professional counsel is a must. Reaching a fair and equitable division of assets that provides both parties with the best opportunity for financial success in the future should be the goal.
Advisers working with divorcing parties must consider their client’s personal financial goals and do everything possible to ensure that the cash flow from the assets awarded to them in the divorce will support those goals. Adjustments to one or both parties’ lifestyle may be required; a party who has not been participating in the workforce may need to consider re-entry. Preparing a budget and cash flow projection that includes the tax planning from the asset division and ongoing implications can provide the client with the necessary information and confidence to make sound financial decisions about their future.
From an income tax perspective, when people go through a legal separation or divorce, the change in their relationship status will also impact their tax situation. Below is a summary of key considerations that they will need to understand and the changes they need to make to avoid an unexpected balance due when filing their returns under their new marital status:
- Filing Status: The IRS considers a couple married for filing purposes until they get a final decree of divorce or separate maintenance. Individuals who are legally separated or divorced at the end of the tax year should file as single unless they are eligible to file as head of household or they remarry by December 31.
- Dependents: Divorce can affect the ability to claim dependents, which can impact the amount of tax owed. Consider available tax credits for single parents, such as the Child Tax Credit and the Earned Income Tax Credit, which can provide financial relief. It is vital to have clear agreement on how or if the dependents will be claimed by the former spouses.
- Retirement Accounts: Early withdrawals from retirement accounts to cover divorce expenses may trigger additional taxes and the possibility of penalties.
- Itemized Deductions: Divorce and the resulting change in filing status can affect deductions normally taken on Schedule A of Form 1040, including medical expenses, mortgage interest, real estate taxes, general sales tax, and gifts to charity.
- Other Income: Income earned from a second job, gig-economy “side hustles,” or starting a new business after a divorce can all generate taxable income that is likely to affect taxes owed.
- Tax Payments: Parties who are paid as employees and having taxes withheld may need to adjust their federal income tax withholding or make estimated tax payments in excess of withholding, given their new filing status.
The Internal Revenue Service website provides additional information about these important matters (see the link at the end of this article).
Divorce is a complex process with significant financial and tax consequences. Careful planning and professional guidance are essential to ensure a fair and equitable outcome for all parties involved.
If you or someone you know has questions or concerns about the tax and other financial implications of divorce, please consult with a member of our tax or financial team to help navigate the process. Our goal is to help those impacted by divorce or separation by reducing the overall stress and providing the clarity you need to make good financial decisions for your future.
Internal Revenue Service website
Disclosure: JFS is not a law firm and does not provide legal services. These materials are for informational purposes only and should not be construed as legal advice. If you require legal advice, please consult with a licensed attorney.
