Divorce: Your Changing Tax Picture

If you're faced with a divorce, you need to be aware of a variety of general considerations about your tax situation.

Divorce expenses. Expenses for obtaining a divorce are not deductible; however, you can deduct certain fees aid for tax advice in connection with a divorce or to obtain alimony.

Filing status. Most married couples file a joint return, which provides a variety of tax advantages. A divorce, of course, changes that. In general, you are considered married for the entire year and can continue to file jointly if you have not obtained a final decree of divorce or separate maintenance by the last day of the tax year, Dec. 31.*

Personal exemptions. If you obtained a final divorce decree or separate maintenance by the end of the year, you must file differently (i.e., as single or head of household), and you cannot take your former spouse's exemption- even if you provided all of his or her support.

Exemptions for dependents. In general, it's the custodial parent - the parent with whom the child lived for the greater part of the year - who takes the exemption for a child. However, the custodial parent can make a written declaration that lets the noncustodial parent take the exemption.

Alimony. The payer can deduct alimony - payments from a spouse to a former spouse under a decree of divorce or separate maintenance - and the recipient must report the amounts received as income. Keep in mind that not all payments made under a divorce or separation agreement are considered alimony; these rules apply only to alimony payments. Your tax advisor can help determine which payments qualify as alimony.

Child support. Child support payments are neither deductible by the payer nor taxable to the payee.

Pre-or post-nuptial agreements. A pre-nuptial or post-nuptial agreement can change how certain assets and/or income will be handled in a divorce. Before signing any agreement, be sure to discuss the implications with legal and tax advisors who are knowledgeable in divorce and taxes. This step is essential to providing an equitable settlement.

Managing Retirement Accounts
If you contribute to your employer's qualified retirement plan, such as a 401(k), or to an IRA, you're probably planning to use those funds to finance a significant portion of the expenses you'll incur in retirement. In a divorce, you need to take measures to help protect these assets.

If you or your spouse has funds in an employer-sponsored retirement plan, it's usually vital to obtain a qualified domestic relations order (QDRO, pronounced "quad row''). This is a court order, judgment or decree related to child support, alimony or property rights that instructs a retirement plan on how to pay benefits to an ex-spouse. QDROs apply to qualified plans covered by the Employee Retirement Income Security Act (ERISA).

A QDRO provides protection above and beyond what a divorce decree offers; don't assume you're protected just because your divorce decree indicates you have a right to your ex-spouse's pension funds. To help ensure your rights are protected, consult with your attorney about obtaining a QDRO.

A QDRO establishes a spouse's right to receive a designated portion of an ex-spouse's retirement plan account balance or benefit payments. The spouse receiving the money accepts responsibility for paying the taxes. Any money going from your pension plan to a nonspouse dependent is considered a distribution to you - which means you would be responsible for paying the taxes.

If you plan to use a QDRO to roll over funds from an ex-spouse's retirement plan into your IRA, keep in mind that an immediate distribution may not be possible. When you receive the money depends on the employer's plan document. If an immediate distribution is possible, take care regarding how the rollover is handled. The most efficient method is to have the money go directly from the retirement plan into your IRA.

Stock Options and Restricted Stock Create Complications
Stock  options and restricted stock have become increasingly popular elements in many employees' compensation packages. Although these can be valuable benefits, they can add complexity to divorce proceedings.

Dealing with stock options is complicated by a variety of factors, including whether:

  • The options are vested or unvested
  • You live in a community-property state
  • You hold incentive stock options (ISOs) or nonqualified stock options (NSOs)

Vested versus unvested options. If you hold unvested stock options, you can claim that they're worthless (because they cannot be exercised) and therefore should not be considered property acquired during the marriage, potentially giving your spouse a claim to them. However, the court may rule that your stock option became marital property on the grant date (when they were issued) rather than when they become vested.

If your unvested options are deemed marital property, your divorce decree must include language stipulating what will happen when the options become exercisable. For example, the court may rule that you and your spouse hold the unvested options as "tenants in common." When the options become vested, your ex-spouse would then have the right to exercise the options through you.

If you hold vested options, the court could rule in a number of ways, for example:

  • If your option program permits transfers, you could be required to transfer a portion of your options to your ex-spouse.
  • If your program does not permit transfers, the court may:
  • Require that you exercise the options and divide the proceeds with your ex-spouse
  • Let you maintain ownership of the options after the divorce and exercise them at a time agreeable to you and your ex-spouse and divide the proceeds
  • Give your ex-spouse other assets of comparable value to the options in exchange for relinquishing any claim to the stock options

Review Estate Strategies and Beneficiary Designations
The Law Firm of Jeffrey M. Rosenblum, PC can guide you with estate strategies and documents that you have in place, including a will, power of attorney or trust.