How to Avoid Paying Taxes on a Divorce Settlement
The attorneys at Mills & Anderson practice business and family law. Our experience with these areas of the law means we can offer unique insights and knowledge about the financial side of divorce. Reach out today to learn more about our services.
Property Division
The Internal Revenue Service (IRS) does not tax gifts from one spouse to the other. The same is true of divorce transfers. To be tax exempt, the property must be divided incident to divorce. Transfers incident to divorce are related to the end of your marriage or occur within one year of your divorce becoming official.
The IRS presumes a transfer made within six years of your divorce based on your divorce agreement is related to your marriage. Transfers that do not meet either qualifier can still be incident to divorce if the transfer was nevertheless related to the end of your marriage. For example, a transfer may be delayed by legal impediments for several years, or one spouse may have concealed assets from the other.
How to Avoid Paying Taxes on Alimony
Congress changed the tax treatment of alimony in 2018, effective in 2019. As a result, alimony taxes vary by the year your divorce becomes final.
Defining Alimony
Under federal tax law, alimony (i.e., separate maintenance) are payments made by one spouse to the other based on a divorce or separation decree or agreement. Payments count as alimony when:
- Payments are made using cash, checks, or money orders;
- Obligations to pay end if the recipient dies;
- Payments are not treated as child support or a property settlement; and
- Payments are not treated as deductible by the payer spouse or includable in the recipient’s gross income.
The spouses must also not file jointly or be members of the same household.
Several types of payments are not alimony, including:
- Child support,
- Noncash property settlements,
- Parts of a spouse’s community property income,
- Payments to maintain the payor’s property,
- Use of the payor’s property, and
- Voluntary payments that are not part of a divorce or separation decree.
With careful planning and negotiation, you may avoid or minimize taxes on spousal support payments by characterizing the payments one way or another.
Alimony Pre-2019
Before 2019, the payer spouse could deduct alimony payments from their taxes, and the recipient was taxed on the alimony as part of their income. Unless the divorce or separation agreement specifies otherwise, agreements that went into effect before 2019 still follow this rule.
Alimony 2019 Forward
Starting January 1, 2019, the payer spouse can no longer deduct alimony. They must pay income tax on the money before sending it as alimony, and the recipient spouse no longer includes it in their gross income.
Retirement Benefits
Generally, you need a qualified domestic relations order (QDRO) to divide retirement benefits between former spouses. When you receive retirement payments under a QDRO, those payments generally count as income. However, you can transfer assets from your IRA to your spouse’s IRA tax-free if you make the transfer incident to divorce. This option can save headaches in the long term and may work well as a negotiation tactic.
Government employees have different retirement benefits. If your former spouse was a federal employee, their federal government employer will need a court order directing the Office of Personnel Management (OPM) to pay you or vice versa.
In Nevada, you must strictly ensure your QDRO complies with Nevada law to receive benefits from a public employee’s plan as their former spouse. You may submit a draft to the Public Employees’ Retirement System (PERS) to request the agency evaluate your QDRO before you finalize the order. Failing to follow these requirements may result in the retirement agency refusing to make payments to a former spouse.
Filing Status
You may save on taxes post-divorce if you take advantage of your filing status options. Generally, you can file as a:
- Married couple filing jointly,
- Married couple filing separately,
- Single person, or
- Head of household.
When married, you decide whether to file jointly or separately.
Timing Your Divorce
You cannot file as married in the year a legal separation order or divorce decree becomes effective. Since most couples benefit from filing jointly, you may minimize your tax burden by waiting until the year ends for your divorce to become effective.
Filing As Head of Household
When you file as head of household, you typically pay lower taxes. You may file as head of household if you:
- Are legally considered unmarried on the last day of the year;
- File a separate return;
- Paid at least half of the upkeep costs on your home for the year;
- Did not live with your former spouse for the second half of the year;
- Have a child, stepchild, or foster child whose main home for more than half the year was your home; and
- Can claim the child as a dependent.
Even if the noncustodial parent claims the child as their dependent, only the custodial parent can typically file as head of household. If you share custody 50/50, either spouse may file.
Credits and Deductions
Some credits and deductions may help you minimize your tax burdens, and these credits are typically related to children and dependents. Notably, child support payments are neither deductible by the payer nor taxable to the recipient, aligning child support with the 2019 alimony rules.
Claiming Dependents
To qualify as your dependent, a child must:
- Be your biological child, adopted child, foster child, stepchild, sibling, half-sibling, stepsibling, or their descendant;
- Be younger than you unless permanently disabled;
- Be 19 or younger if not a student or 24 or younger if a student, unless permanently disabled;
- Have lived with you for more than half the year;
- Not provide half of their own support for the year; and
- Not file a joint return.
The noncustodial parent usually cannot claim a child as a dependent. However, if the custodial parent declared that they will not claim the child as a dependent in writing, the noncustodial parent may claim them as a dependent.
Other Tax Credits and Deductions
Additionally, you may claim the child and dependent care expense credit if you cared for a child under age 13 or a dependent incapable of caring for themself due to disability. You may also claim the child tax credit for dependents who are under 17 at the end of the year.
Mills & Anderson Can Help
Minimizing your tax bill after divorce often requires careful planning, give-and-take with your former spouse, and extensive knowledge of the available options. For assistance from lawyers with the knowledge and experience to advise you, help you make your plan, and negotiate with your former spouse, contact Mills & Anderson today.
