3 Mistakes To Avoid For A Tax-Smart Divorce

Divorce is expensive - time, energy, emotionally and of course, legal fees. And while transferring assets between spouses due to divorce does not generally result in a tax consequence, repositioning assets to create cash flow and a strategy to align with your individual goals likely will.

Avoiding these three mistakes will enable you to be smart and proactive about your taxes to minimize Uncle Sam’s cut without needing to become a tax expert.

Don’t get tripped up by “taxbergs”

First, a pro tip: it pays to focus not just on the value of the assets you’re dividing, but also on the cash implications of this split, now, and in the future. Making tax-savvy divorce moves will increase the chances that you’ll end up with more cash in your pocket in the end.

Remember the Titanic? What looked barely visible on the surface hid a lot of danger underneath. That’s exactly the case with many assets that look “equal” on the surface. But some of them are big, silent icebergs that pack a mean punch when tax time comes.

Here are a couple of real examples:

The Smiths, John and Jane, have a traditional IRA and a Roth IRA, each with a balance of $100,000. For simplicity, John was going to take the IRA and Jane the Roth IRA. Looks equal, right?

In fact, these assets are not equal at all. The traditional IRA holds money that has never been taxed and, as such, hides lots of unpaid taxes under the surface. When it comes time to withdraw, the person with the traditional IRA could pay taxes as high as 35% (or whatever the rate at which their next dollar of ordinary income gets taxed). Translation: as much as $35,000 goes to the IRS – and they’ll keep 65 cents for every dollar they got in the divorce.

The Roth IRA, on the other hand, has already paid its dues and has been given the “all-clear” for tax purposes. So, the lucky recipient of the Roth IRA gets a full dollar for every dollar they got in the split. Which would you rather get?

Let’s look at another common example. What if, instead of IRAs, John and Jane have two holdings of the same stock, each currently worth $100,000. “Should be about equal,” anyone might think, but that may not be the case at all.

One lot was bought when the price was low, and the stock cost only $45,000. The second lot was bought much later, for $90,000. When the stocks are sold, the first sale gets a $11,000 tax bill – assuming the profit of $55,000 gets taxed at a 20% capital gains tax rate. The holder of the first lot keeps $89,000 after taxes. On the other hand, the second sale gets away lightly, because the tax bill is only $2,000 on $10,000 profit. The holder of the second lot keeps substantially more - $98,000.

Moral of the story: when splitting assets, avoid a Titanic mistake by ensuring you don’t get tripped up by an “equal” division - look for the “taxberg,” a.k.a. the tax iceberg hiding under every asset!

Don’t be humble – take “credit” where it’s due

Are kids part of your divorce equation?

If yes, you should think about not only the credit for being a great parent, but also about the “credits” you may be entitled to from Uncle Sam.

First, a little history tour to give you context. Before 2018, when the new U.S. tax law went into effect, one parent could claim a “dependency exemption” of about $4,000 per child. This exemption reduced the amount of their taxable income.

In a divorce, the person eligible to claim the dependency exemption is generally the “custodial parent” as the IRS defines it – i.e., the parent with whom the child spent more overnights. If the child split their nights equally, the custodial parent is the one making more money.

The new tax law “zeroed out” the amount of that exemption, but only through 2025, when it’s scheduled to kick back into its pre-2018 form.

Though the dependency exemption is $0 towards your taxes today, it may still provide value now and in future due to the following:

1.     The person entitled to the dependency exemption holds the keys to all other child-related tax benefits in the intervening years, provided their income isn’t too high to qualify. This includes the child-tax credit, educational credit, earned income credit, and child-care credit.

2.    The exemption is scheduled to come back in 2026, so if your kids are young make sure this valuable right is carefully considered.

If you expect to make significantly less money post-divorce, consider parental responsibilities and the dependency exemption carefully to be sure you make the right child-related decisions in divorce, so they don’t come back to bite you later.

Don’t forget tax benefits from your marriage

1.     Have a tax refund coming? Ensure the refund is put on the table as part of your settlement negotiations.

2.    Are you or your spouse involved in a business or have losses from selling stocks or investments? If so, you may have some “loss carry forwards.” These are prior-year losses that the IRS allows you to use to reduce future taxable income, and your future tax bill.

In the heat of divorce negotiations, it’s easy to forget these amounts and let them slip. Be sure to track prior year returns to identify any carry forwards and include them in your settlement negotiations.

One last caution: while still married, be careful signing joint returns – if you do, the IRS could demand any underpayment of taxes from you, even if your divorce has been finalized. If in doubt, file as married filing separately, or insist on a tax indemnification agreement to protect yourself.

What to do next:

Getting a head start on these potentially big opportunities doesn’t need to be hard:

• Consider the tax impacts of all assets to be split in your settlement – make sure the after-tax numbers are what get counted in the decision
• Think about the implications of making child-related tax decisions, especially with the dependency exemption
• Comb through prior year returns to ensure you’re not missing out on credit for loss carry forwards
• Be careful signing joint tax returns when going through divorce – always protect yourself first

Better still, hire a smart team including an experienced divorce financial professional and attorney on your side to get you the most bang for your tax buck – so you can focus on really enjoying the next chapter of your post-divorce life.

How can you benefit from Uncle Sam to make your divorce tax-smart?