Tax Traps in Divorce

It is generally regarded that there are only two things in life that are certain: death and taxes. This may be true, but it can become substantially more complicated in situations involving divorce. In the midst of stressful divorce negotiations, spouses may forget that any action that they take could have an impact on the amount that is owed in taxes. Luckily, being informed, planning ahead, and consulting a knowledgeable team of family law attorneys and tax professionals can save you from making mistakes that will cost you money in the long run.

Here are the top 5 tax traps to avoid:

  • Transfer of retirement funds. Most people know that if you withdraw funds from your retirement account or 401(k) too early, you may have to pay some type of tax penalty. The rules don't change if you are divorcing and separating your assets. If you withdraw funds from your retirement account prior to retirement age, then you may be subjecting yourself to the same tax penalty, even if it is an attempt to divide a marital asset.

How to avoid the trap: Ask your attorney about arranging an "institutional transfer" of your retirement funds. The tax code does not consider this to be a "withdrawal," and you can therefore separate your retirement funds with no tax penalty.

  • Early withdrawal of retirement funds: Similar to the last tip, if you are younger than 59 ½ and you withdraw from your retirement account, you could be faced with paying a 10 percent penalty on your savings.

How to avoid the trap: Be informed. Know the terms of your retirement plan. Talk to your family law attorney and your accountant about ways to avoid the trap, such as setting up an institutional transfer.

  • Alimony Taxation: Did you know that you have to pay taxes on the alimony that you receive? The payor spouse can deduct the payments, but the spouse receiving it must include it in their gross income for tax purposes. If you don't include the taxes in your monthly budget, then you could be faced with a large tax bill at the end of the year.

How to avoid the trap: Plan ahead. Understand how much tax you will have to pay on your alimony, based on your monthly income. Request the appropriate amount of alimony that will be enough to cover your financial needs AND the required taxes.

  • Tax Credits and Capital Gains: Deductions and capital gains and losses are valuable additions to lowering your overall tax burden. Like any other property that is earned during a marriage, they are divisible marital property incident to a divorce. Losing out on any beneficial tax treatment could lead to substantially higher taxes.

How to avoid the trap: Work with an experienced family law attorney to ensure that any tax credits, or capital gains or losses are addressed in your Marriage Settlement Agreement. When inventorying your marital assets, list any and all tax benefits that you have carried over, and make sure that they are equitably divided along with all other property.

  • Deducting Attorney's Fees: Depending on your particular tax situation, you may be able to deduct attorney's fees incurred that can be attributed to receiving alimony or retirement funds. This could potentially be a significant deduction, which could lead to a much higher tax bill if ignored

How to avoid the trap: Calculate your taxable income, and speak with your team of family law tax professionals to determine what, if any, charges qualify for deduction.

These are five of the most common traps, and all can be avoided through planning, care and consultation with your team of experienced family law and tax professionals. Divorce is hard enough already, you shouldn't have to worry about any tax surprises during the process. Remember, everyone's situation is different, so make sure that you consult with a divorce attorney and tax professional to discuss your unique financial situation.