So you have passed the brink of no return in your relationship and decided to file for divorce. Before you do, it’s wise to make some financial preparations ahead of your court date. Getting pictures of assets, copies of bank statements and any retirement accounts is a good start.
Maybe the division of property and debts will be done equitably, but compromise is harder if either of the divorcing spouses carry bitter feelings. Whether there is a spirit of concession or it is an ongoing "War of Roses," your annual federal and state taxes must be contended with too.
In this article, I will discuss the pros and cons of filing your taxes individually or jointly during divorce. You will find there are some exceptions for extenuating circumstances and some arduous facts that you should quickly acquaint yourself with.
How Should I File My Taxes During a Divorce?
The primary consideration to take into account when determining the type of filing you will make is your marital status on December 31. If you are married on this day under your state’s law, then you are considered married for the entirety of that year.
If you are divorced or legally separated under state law on December 31, then you are deemed to have been unmarried for the rest of that year.
As an unmarried person, you may file as single or Head of Household if you can claim a qualified dependent. You may also file under the Head of Household status if you have been separated from your spouse longer than 6 months and are also eligible to claim a qualified dependent.
If you are married, you may file separately or jointly. For most couples, a joint filing will allow for more tax savings than would otherwise be realized if both spouses should choose to file separately.
>However, this may not be the case for everyone, and it would be beneficial to ask your tax preparer to compare your liability or refund under both options. Even if you are in the process of divorce, if you have not received a final divorce decree by December 31, you may still file jointly and take advantage of the tax savings if you would prefer to do so.
Pros of Filing Jointly
As mentioned above, the tax code allows for couples to file jointly. When filing jointly, both spouses report their income. Many couples choose to file jointly to take advantage of the additional credits and deductions that are available to joint filers. For example, couples who file a joint return qualify for a much larger standard deduction than those who file separately; $24,400 compared to $12,200 for those who opt to file alone.
Aside from the deductions and credits available, joint filers may also qualify for a lower tax bracket. This typically applies to couples with a financial situation where one spouse earns significantly more than the other. Unfortunately, this type of financial situation sometimes involves spouses who do not completely understand the implications of signing a joint return.
Cons of Filing Jointly
While there are certainly many reasons why a couple may find it advantageous to file together, there are consequences worth considering beforehand.
The fact is, filing jointly means both parties assume each other's tax liability. Therefore, if you choose to file as married filing jointly, your spouse will be responsible for any tax, penalties, and interest that arises from that joint tax return, even if you reported no income on the return.
The next section offers a clearer understanding of what you may personally be responsible for under a married filing jointly tax return.
However, there are exceptions made for certain individuals who it would not be fair for the IRS to go after for a spouse’s error. If you do not believe it is fair that you should pay for a tax liability that your spouse or former spouse incurred, you may potentially qualify for an exemption under the Innocent Spouse Relief provision of the tax code.
Who is Responsible for Tax Debt in a Divorce?
When a taxpayer files separately, it is clear who will bear the burden of any tax liability assessed by the IRS. However, it may not be as intuitive when a tax return is filed on behalf of two taxpayers. If a joint return is filed, the liabilities linked to this return are held joint and several between both taxpayers. This means you are both on the hook for the entire tax liability, until it is paid or released.
Joint and Several Liability for Taxes Between Divorced Spouses
For a clearer understanding of joint and several liability, consider the analogy of an egg toss; where each losing two-man team pays the winning team $10 dollars in total.
In an egg toss, both teammates are individually responsible for keeping the egg intact. Regardless of whether player A makes a wobbly pass or player B fumbled the catch, if the egg is dropped the $10 must be paid up.
If player A only has $3 dollars, joint and several liability means that player B can expect a visit from the winning team for the remaining $7. Regardless of the fact that player A was the one who cracked the egg.
Similar to the winning team in our example, the IRS does not care whether it collects the liability from taxpayer A or taxpayer B (or both). If they can collect the entire amount from you alone then they likely will. If you file a joint return with your spouse and generate $50,000 in taxes owed, both spouses are individually responsible for this $50,000 until it is paid.
Again, one spouse could potentially foot the entire bill if the IRS decides to pursue that spouse. This applies to married couples, and it also applies to former spouses if the tax owed comes from a year where the formerly married couple filed a joint return.
Who Does the IRS Pursue for Payment?
To add insult to injury, the IRS does not follow divorce decree arrangements. Meaning they will still go after both spouses for the entire amount due, even if your divorce judgement or agreement allocates tax liability to one spouse entirely. Even some lawyers fail to understand that family court rulings do not supersede the tax code.
The IRS will continue to pursue either spouse (or both); until the liability is paid or released. These tax bills often include the unpaid tax assessed, interest, and associated penalties for every year under review. This could leave a spouse or former spouse in a very vulnerable financial position, especially if that person relied on their significant other at the time to handle the finances.
The unfairness is typically apparent when one spouse is self-employed, and the other spouse tends to the domestic responsibilities of the home.
Although this is not the only time it would be unfair for a spouse to shoulder the responsibility of their spouse’s action, fortunately, there are exceptions that allow relief for individuals in similar circumstances.
Resolving Tax Liability with a Former Spouse
When clients come in for tax consultation relating to their ongoing divorce, the first step taken is to determine whether it is possible to work with the former spouse to resolve the liability.
hile some may understandably hope to shoulder the task alone, here are a few reasons why working with a former spouse is usually the best first approach when available:
- Facilitates understanding – When both spouses are on the same page and fully understand the amount and reason for the liability they are also facing, they are much better equipped to handle that liability.
- Prevents miscommunication – Being on the same page also helps intercept and correct misunderstandings which could otherwise be leveraged against you by the IRS.
- May help reduce amount owed – The other spouse may have valuable information needed to reduce the liability owed overall or help vindicate you from liability.
That said, it may not come as a surprise to hear that spouses are not always willing to work together during or after divorce. If your spouse had not been honest about finances during your marriage, you may not expect them to be forthcoming now. Perhaps there are other reasons why you would prefer to avoid entanglement.
For some, working together with a former spouse just is not in the cards. If this sounds like the hand you were dealt, resist the urge to fold. You may have other options available.
Joint and Several Liability Exemptions
In either case, we next consider whether you may qualify for any of the following exceptions to liability.
There are the three options available to provide relief from joint and several liability under a joint return:1. Innocent Spouse Relief
This exception provides relief if your spouse (or former spouse):
- failed to report income;
- reported income improperly; or
- claimed improper deductions or credits.
This exclusion provides relief by allocating the liability between you and your former spouse; you then pay only what you owe.3. Equitable Relief
This may provide relief when you don't qualify for innocent spouse relief or separation of liability relief for something not reported properly on a joint return and generally attributable to your spouse. You may also qualify for equitable relief if the amount of tax reported is correct on your joint return, but the tax wasn't paid with the return.
How Transfers of Property are Taxed in a Divorce
You typically have a six-year window of time from the date your divorce is finalized to make a transfer that is not subject to taxation. Once you go beyond six years, you are looking at two individuals who are divorced, and the transfer assets between each other could be considered a gift subject to different rules.
Unless there is a valid reason that is beyond your control, the sooner you complete the transfer, the better off you will be. Because the code specifies that the tax-free transfer must be incident to divorce, it may also help to include what the other spouse will receive under the divorce agreement.
Dividing Retirement Plans
Retirement plans are often divided to pay out a divorcing spouse. However, you would be wise to approach this task with caution. Withdrawing payments from your IRA or 401k can come with a 10 percent penalty if done before a certain age – typically 59 and a half years old.
You can avoid this hefty prepayment penalty by having a Qualified Domestic Relations Order (QDRO) prepared, and then submitted to the court to be executed. The court will send the QDRO to your retirement plan administrator.
Once the paperwork requesting the QDRO is prepared, the plan administrator divides the account. The money can then be withdrawn by the alternate payee. Do not hasten to withdraw the money prior to the completion of the process, otherwise you will lose the provision that allows you to access the funds penalty-free.
Another item to consider with regard to retirement plans is whether there are any outstanding loans that you may have taken out against your retirement funds.
While a loan taken out on your 401k is normally tax-free, if you borrow money from a 401k plan and then liquidate the 401k account, you are likely going to have to pay the taxes on the funds that you withdrew.
Make the Best Choice For Your Situation Before Filing
Working with your former spouse to find the best way to file your taxes during the divorce year is the optimal solution in an often painful life transition. Even when the break up is amicable, there may be difficulties in separating assets without making mistakes that can lead to future tax penalties.
Once you agree on your filing status, there are other decisions that will affect both spouse’s taxes such as: who claims dependent children, reporting alimony and child support, handling the home sale and deducting retirement accounts. Begin with simple tasks like giving your employer a new Form W-4, Employee’s Withholding Certificate within 10 days after the divorce or separation.
On the flip side, your divorce is a battle of wiles and wills. It might be best to file individually. If this is the case, you can choose “married filing separately” or “head of household” depending on your circumstances.
If you are still having difficulty making a decision, call my office at (619) 378-3138 or visit www.sambrotman.com to set up a free one-hour consultation. Divorce and taxes are two of life’s greatest hardships. In my experience, the more money that is involved, the more likely it is that there will be tax issues. Working together we can make the best choice for you to avoid possible IRS entanglements now and in the future.