Divorce is a major life change and can be overwhelming, not just emotionally, but also when dealing with issues such as property division, custodial arrangements, and, in some cases, spousal support.
This life change also requires attention on financial planning. Individuals need to make sure they do not overlook key issues and considerations related to financial planning around taxes, retirement, estate planning, and risk management. It is also important to plan for liquidity and cash management to handle expected expenses from divorce proceedings like legal fees and other unforeseen costs and circumstances.
Change in filing status. Individuals going through divorce should determine the potential impact of filing as an individual taxpayer compared with a couple filing a joint tax return. A taxpayer will need to file as a single individual in the year the divorce agreement is finalized. For those maintaining a similar level of taxable income post-divorce, the results may be eye-opening. Tax brackets will be less favorable and provisions such as the standard deduction will matter ($13,850 for single filers, $27,700 for couples filing a joint return for 2023).
Consider this taxpayer who maintains a similar level of income post-divorce. In this example the taxpayer’s marginal tax bracket increases from 24% while married to 32% as a single filer.
*Based on 2023 tax rates and figures. For pre-divorce, the tax filing status is married filing a joint return. For post-divorce, the calculation is based on a single filer, and assumes the taxpayer in the example is not the custodial parent and therefore not claiming the Child Tax Credit (CTC) for two qualifying dependents.
In this example the individual reports less income as a single filer but ends up paying almost $4,000 more in taxes. The effective tax rate (taxes as a percentage of total income) prior to the divorce for the married couple was 13%, while the effective tax rate for the single filer after the divorce is roughly 18%.
Other tax-related considerations
- Since the passage of the Tax Cuts and Jobs Act (TCJA), spousal support (e.g., alimony) is no longer deductible by the payor and not considered income to the recipient.
- The capital gain exclusion upon the sale of a primary residence decreases from $500,000 for married couples to $250,000 for individuals.
- Who gets to claim tax deductions and credits? In the case of dependents, it is generally the custodial parent, but the IRS has tie-breaker rules if there is a dispute.
- Individuals will want to review their withholding from their employer to determine if changes need to be made. A penalty from the IRS may apply if a taxpayer does not withhold or pay estimated taxes of at least 90% of their tax burden for the year.
Additional planning considerations
Ownership and titling of assets. Make sure to re-title joint accounts, modify deeds on real estate, and review key legal documents like wills, trusts, powers of attorney, and health care proxies. Also, update beneficiary designations on retirement accounts, annuities, and life insurance policies if necessary.
Retirement-related issues. While assets left to a surviving spouse can be distributed gradually, most non-spouse beneficiaries will be subject to the 10-year rule for distributions. This can cause income tax issues if heirs inherit accounts during their peak earning years. Also, inform the Social Security Administration (SSA) about the change in marital status. Ex-spouses who have been married at least 10 years and divorced at least two years may receive spousal benefits.
College financing. Be aware of recent changes related to the Free Application for Federal Student Aid (FAFSA). Historically, financial aid was calculated based on the custodial parent’s financial information. The custodial parent is the one with whom the child has lived for the majority of the year. Divorced parents planning to maximize aid would want to make sure the student lived the majority of their time with the lower-income parent owning less financial assets. However, beginning with the next filing period in the fall of 2023, the calculation will generally be based on the parent who provides the most financial support, regardless of the living arrangements. This may lead to a reduction in financial aid.
Risk management. Review health, home, auto, and other policies to determine whether changes need to be made. For example, disability insurance coverage may be more critical if an individual can’t necessarily rely on their spouse for support.
Wealth transfer. In addition to updating important estate-planning documents, individuals must be aware that the annual and lifetime gift/estate tax exclusions are effectively reduced by half. The unlimited marital deduction exempts transfers between spouses from federal gift and estate taxes.
Seek expert tax advice
In addition to legal considerations, it is important for individuals to consult with their financial advisors and a tax expert. Many financial decisions are solidified in the final agreement and made binding by a judge.
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