What to Consider When Taxpayers Marry or Divorce
Taxpayer Marital Timing
Rescheduling of a marriage or divorce by a single day at year’s end can make a big difference in tax liability in both years. Usually, marital status as of December 31 determines filing status for the full year with the exception that, if a spouse dies during the year, the survivor still may file a joint return. The Internal Revenue Service (IRS) considers a taxpayer who marries on New Year’s Eve as married for the entire year. Similarly, the IRS considers a taxpayer legally separated or divorced on December 31 as single for the entire year.
For taxpayers earning about the same, marriage before the end of the year can be costly. Their tax liability on the combined incomes can be considerably more than it would be on the sum of their incomes reported separately, in effect a “marriage penalty,” but by postponing their marriage into the next year the taxpayers get a reprieve from the marriage penalty for that year. Conversely, marriage can save taxpayers money when one earns considerably more than the other.
The IRS Applies Similar Rules to Taxpayers Who Divorce
If they divorce near the end of the year, they lose the option to file jointly for the entire year. If single status is advantageous, to qualify for it they must be in fact legally separated or divorced by December 31.
Each year stands alone. Married couples might face the penalty in some years and enjoy tax savings in others. Taxpayers William Jefferson and Hillary Rodham Clinton paid the penalty from 1983 to 1992, when his annual salary as Governor of Arkansas was $35,000 and she earned much more as a Little Rock law firm partner. They saved money from 1993 to 2000, when his annual salary as President of the United States was $200,000 as the sole family taxpayer until she entered the Senate in January 2001.
Some Dual-Income Couples Manipulate the Marriage Penalty Aspects of The Tax Code
Increasingly, such couples get divorces in December and then remarry in January. Some have revealed on national television that they divorce and remarry annually so they can file as two single taxpayers and save money, frolic for a week or so, and buy some extra Christmas presents with what they save.
At the IRS, under Revenue Ruling 76–253 the agency disregards divorces solely to save money on taxes and requires recalculations as if the taxpayers had stayed married for the whole year, making them liable for not only additional taxes but also interest and perhaps penalties.
Taxpayer Divorce Planning
Taxpayers negotiating separations should consult with tax professionals on arrangements that could lighten their tax burdens:
– Filing Status. Taxpayers still legally married on December 31 may file jointly. If they divorce and agree on claims for children as dependents, they can file as single heads of households for better tax treatment. Regardless of custody provisions, taxpayers can agree out of court on who claims children as dependents.
– Medical Expenses. Typically, the parent who pays for the child’s medical expenses can claim deductions for them.
– Alimony. The party awarded alimony must pay taxes on that income. The party paying alimony may deduct it from taxable income.
– Child Support. Child support is always tax-neutral with no effect on either divorced taxpayer’s income.
– Retirement Investments. A divorced party who withdraws from a defined-contribution pension account may face early withdrawal penalties, and the IRS considers the withdrawal taxable income. Withdrawal and transfer under a qualified domestic relations order avoids this tax liability.
– Capital Gains. Single filers can shelter up to $250,000 in proceeds on the sale of a primary residence, married couples filing jointly up to $500,000. Taxpayers who stand to gain more may time their divorce and home sale accordingly. Such tax breaks are available only to those who have lived in the home at least two of the past five years.
– Mortgage interest. The spouse acquiring the home also claims the mortgage interest deduction regardless of who lives in the home or makes the mortgage payments. If both continue to own it jointly, both may split the deduction.
Cooperation between Divorcing Taxpayers
Taxpayers can determine many tax decisions best for themselves if they act in good faith with one another on the payment of any income tax balance due on a joint return and the shares of any refunds. Transfers between divorcing taxpayers in property settlements are gifts and not taxable, but to pay settlements sometimes taxpayers must use assets in ways that incur tax consequences. Withdrawals of funds from restricted accounts may cause tax liabilities. Sales of assets received in settlements may produce taxable capital gains.
Tax credits, another consideration for divorcing taxpayers, can result in refunds. The earned income tax credit is refundable, as are the child and dependent care credit available to taxpayers who must incur expenses in order to work and the child tax credit available to taxpayers claiming dependency exemptions for children under 17. Divorcing couples can sometimes reduce their taxes by such credits. The IRS is indifferent as to which parent claims the exemption, but both cannot.
Hopefully, this post inspired you to advise your business clients on business and divorce issues more proactively. Along with that, consider simplifying your efforts this tax season. For instance, if you’re not tax filing online, you need to. Choosing to efile 1099 and other tax forms will save time and expenses.
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