It is important to consider the various tax consequences in the context of divorce in order to enter into the most beneficial support arrangement for divorcing spouses and determine how to prudently divide assets. A tax analysis can be a useful tool in an effort to support a settlement position and illustrate the overall after-tax impact on the family unit.
With respect to support – be it child support or alimony (spousal support) – there are important tax related considerations that parties and counsel should keep in mind when structuring a support arrangement. Child support is not taxable income to the recipient parent and it is not deductible for the payor spouse. In contrast, alimony is included as taxable income to the recipient spouse and is tax deductible for the payor spouse. Often, given that alimony has a significant tax benefit to the payor spouse, parties may enter an agreement wherein the parties agree to an “unallocated support” order which is treated as alimony for tax purposes, or they may create a support obligation wherein the payor spouse pays some alimony and some child support. In some circumstances, especially where the payor parent is in a high tax bracket and the recipient parent is in a low tax bracket, a higher alimony payment may be more beneficial for both parties than a straight child support payment; putting more money in the pocket of the recipient and providing a dollar for dollar tax deduction to the payor.
Parties and counsel should discuss the pros and cons of the parties’ income tax filing status during divorce proceedings and prior to the entry of the Judgment on Divorce (i.e. married filing jointly vs. married filing separately or head of household). Filing jointly is typically a more beneficial filing status than married filing separately. In addition, parties and counsel should prospectively consider how/if dependency exemptions, real estate tax and mortgage interest exemptions will be shared. In some cases such exemptions may not be available to a high earner as such exemptions are phased-out in higher tax brackets or due to Alternative Minimum Tax. It is important to include specific language in a Separation Agreement regarding tax exemptions and which party is entitled to claim same to prevent confusion down the road.
Finally, in dividing assets at the time of divorce, parties and counsel should bear in mind the difference between liquid assets such as bank accounts, mutual funds, etc. and pre-tax assets including IRAs, 401(k)s and other retirement accounts (excluding Roth IRAs). By way of example, it would not be an equal division for one party to receive $100,000 in cash from a checking account and the other party receives $100,000 in pre-tax retirement assets. Although each party is receiving $100,000, the party receiving pre-tax retirement funds is actually receiving less than $100,000 because said funds have not yet been taxed.
Whether or not you seek the opinion of a tax expert, parties and counsel should not overlook the various scenarios in the context of divorce wherein tax consequences should be considered and addressed.