Divorcing couples quickly realize that they need to determine how to divide their assets, how to structure custodial arrangements for their children, and how much support will be exchanged. Most divorcing couples come to the table knowing that division of assets, time with children, and money are all areas central to reaching a settlement. Others are aware that they also need to address questions pertaining to health insurance coverage and even life insurance. Few, however, consider the tax implications of their agreements.
At the Centre for Mediation and Dispute Resolution, we suggest that all agreements need to include consideration of tax implications, lest you realize tomorrow that the agreements you reached do not provide you with the moneys you anticipated at the time of settlement.
The following represents a sampling of areas with tax implications, which should be included, where applicable, in your divorce settlement:
Dependency exemptions can be retained by the residential parent or waived to the other parent.
Child tax credit cannot be separated from the dependency exemption and is income capped. As such the parent who claims the dependency exemption also has eligibility for the child tax credit, if income eligible.
Head of household status may need to be negotiated in a shared custodial arrangement where there is only one child.
Education-related credits and/or deductions are also income capped.
Real Estate Sales
It is necessary to calculate the capital gains taxes and, if an investment property, to consider gains or any applicable losses.
In the sale of the marital home, consider, for high-end houses, the structuring of an agreement that includes the non-resident spouse’s tax exclusion. Here, striking a bargain may well pay off for both spouses.
Investment Gains and Losses
In structuring your agreement, be sure that you and your spouse consider the impact of losses and gains in the calculation of moneys received by each party. (For inheritance funds: be sure that you use the correct basis in undertaking your calculation.)
Consider penalties and taxes for early withdrawals.
Be aware that retirement funds can be transferred from 40lk(s) from one spouse to the other and withdrawn without penalty prior to retirement age. (Taxes will still be owed.)
Project the tax-deferred growth of funds prior to withdrawal and taxes owed in the future.
Life Insurance Policies (w/Equity)
Be aware that ordinary income taxes will be incurred on the cash received from surrender of policies if the amount of the premiums paid is less than the amount of the cash surrender value.
Term Life Insurance
Typically payouts from term life insurance policies are not considered income.
Transfer of Property
Transfers of assets in divorce generally constitute a tax-free transfer to the recipient. Retirement funds can also be transferred from one spouse to the other without any tax implications provided that the funds stay in tax-deferred retirement accounts.
Child support is received by the recipient as nontaxable income. As such the paying spouse makes the payment in after-tax dollars.
Alimony can be taxable to the recipient and deductible to the paying party or, if the parties agree, payments can be nontaxable and nondeductible and therefore mirror child support payments in their tax impact.
It is important to note that the terms of your agreement can result in a taxable event unintended by the parties. Therefore support payments need to be structured with full awareness of the tax pitfalls and implications under various situations.
The above list constitutes only a smattering of the many tax implications inherent in each couple’s divorce settlement. In order to protect both spouses from unpleasant surprises, it is crucial for both parties to understand what they are receiving and what they are really giving up in fashioning their agreement. Often parties can create better, more beneficial agreements, by “giving” to their spouse in areas that will not have a negative impact on their own settlement. The problem-solving element of mediation presents an ideal forum for analyzing tax implications and weighing their “value” to each party…. In the end, the parties’ agreement should focus on tax savings and advantages to be achieved by both parties sharing the common goal of optimizing the “goodness” of their agreement for the family.