Because federal tax law reaches deep into all aspects of our lives, it’s no surprise that the rules that affect us change as our lives change. This can present opportunities to save or create costly pitfalls to avoid. Being alert to the rolling changes that come at various life stages is the key to holding down your tax bill to the legal minimum.
For starters, plan on filing a W-4 form with your employer to increase or decrease the amount withheld from your paychecks.
2. Legal Fees
Most legal fees associated with a divorce are considered nondeductible personal expenses. But there are exceptions that could save you money.
To the extent your lawyer’s work focuses on alimony (the recipient has to pay tax on it; the payer gets to deduct it) or other tax issues (like who gets the dependency exemptions or the intricacies of transfers of assets between spouses), that portion of the bill is deductible as a miscellaneous expense if you itemize. A key to this tax-saver is to have your attorney clearly break out the tax-related portion of the bill from the personal part. As miscellaneous expenses, qualifying costs are deductible only to the extent all your miscellaneous expenses exceed 2 percent of your adjusted gross income.
3. Exemptions for Children
As a general rule, the custodial parent (the one the kids live with most of the year) claims qualifying children as dependents on the tax return. (For 2014, each dependency exemption reduces taxable income by $3,950. The amount rises to $4,000 for 2015 returns.)
But it is perfectly legal for the noncustodial parent to claim a son or daughter as his or her dependent if the other parent signs a waiver agreeing not to claim the same child on his or her return. Form 8332 must accompany the noncustodial parent’s return each year he or she claims the children. This could make financial sense if the noncustodial parent is in a higher tax bracket. But note this: Waiving the right to the exemption also waives the right to claim the child credit and any college credits. Those tax savers can only be claimed by the parent who claims the child as a dependent.
4. Filing Status
Couples who are splitting up but not yet divorced before the end of the year still have the option to file a joint return. It’s your marital status as of Dec. 31 that controls your filing status. If you can’t file a joint return for the year, you can file as a head of household after your divorce (and get the benefit of a bigger standard deduction and gentler tax brackets) if you had a dependent living with you for more than half the year and you paid for more than half of the upkeep for your home. If your divorce is still pending at year-end, you can either file a joint return (which is likely to save you money) or choose the married-filing-separately status.
5. Medical Expenses
If you continue to pay a child’s medical bills after the divorce, you can include those costs in your medical-expense deductions even if your ex-spouse has custody of the child and claims the dependency exemption. The child’s bills you pay could push you over the 10% threshold that applies to most taxpayers when it comes to medical-expense deductions. The costs are deductible only to the extent that they exceed 10% of adjusted gross income. (It’s 7.5% of AGI if you’re 65 or older.)
6. Asset Transfers
When a divorce settlement shifts property from one spouse to another, the recipient doesn’t pay tax on that transfer. That’s the good news.
But it’s important to remember that the property’s tax basis shifts as well. Thus, if you get property from your ex in the divorce and later sell it, you will pay capital gains tax on all the appreciation before as well as after the transfer. That’s why, when you’re splitting up property, you need to consider the tax basis as well as the value of the property. A $100,000 bank account is worth more to you than a $100,000 stock portfolio that has a basis of $50,000. There’s no tax on the former, but when you sell the stock, you will owe tax on the $50,000 profit.
7. Home Sales
If, as part of your divorce, you and your ex decide to sell your home, the timing can have tax consequences. Normally, the law allows you to avoid tax on the first $250,000 of gain on the sale of your primary home if you have owned the home and lived there at least two years out of the last five. Married couples filing jointly can exclude up to $500,000. For sales after a divorce, if the two-year ownership-and-use tests are met, you and your ex can each exclude up to $250,000 of gain on your individual returns. And sales after a divorce can qualify for a reduced exclusion even if the two-year tests haven’t been met.
The limit on tax-free profit depends on the portion of the two-year period for which the home was owned and used. If, for example, it was one year instead of two, you each can exclude $125,000 of gain. What happens if you receive the house in the divorce settlement and sell it several years later? Then you are stuck with the $250,000 maximum.
8. IRA Contributions
Generally, a taxpayer must have earned income from a job or self employment to qualify to contribute to an individual retirement account. However, there’s an exception for some divorced people.
Taxable alimony you receive counts as compensation for the purposes of making IRA contributions. For 2014 and 2015, assuming you’re at least 50 years old, you can contribute up to $6,500 to a traditional IRA or a Roth IRA or a combination of the two.