By Ingrid Case
PHOENIX — Divorce is an emotional blow, but with good financial advice, it doesn’t have to be a tax hit as well.
“The IRS doesn’t have the resources to help a lot around this topic,” Justin Miller, a national wealth strategist at BNY Mellon in San Francisco, said at NAPFA’s spring conference in May.
That provides a huge opportunity for advisers, he said.
Miller offered some tips for advisers who are helping clients financially get through a divorce.
1. Tax filing status. Divorcing couples can file their taxes as married filing jointly, married filing singly or as single and/or head of household.
“If you’re married on Dec. 31, you’re married for that tax year. That’s a planning opportunity,” Miller said.
“At $450,000 a year, you’re in the highest tax bracket for a single person but not if you’re married,” he said. “In this situation, being married is a tax benefit, so maybe we push the divorce into the following year.”
On the other hand, “if you each make $250,000 a year, as single people you’re not in the highest bracket, but as married people you are. Probably better to get the divorce done this year,” Miller said.
Married filing jointly is usually the right way to go, though married filing separately might make sense if one spouse has a lot of medical expenses, he said.
“If there’s any question that the spouse is creating tax trouble, file separately,” Miller said.
Clients who plan to reclaim the names that they had before marriage shouldn’t use that name on a tax return until they have filed the change with Social Security.
“If the IRS doesn’t match your name to Social Security records, there will be huge delays and you may get threatening letters,” Miller said.
2. Dependency exemption. The custodial parent, or the parent with whom the child spends more nights, is usually the person who gets a dependent credit.
But parents can trade the dependency credit if one makes too much or too little to benefit from the credit.
“You can still qualify as head of household if you’ve been living apart for more than six months and you provided more than half the cost of a home for your child,” Miller said.
Parents can also alternate who claims the child credit from year to year.
3. Sale of principal residence exclusion. For those filing singly, $250,000 of the gain on the principal residence is tax-free; the number is $500,000 for those married and filing jointly.
Usually, it is better to have the larger exclusion, Miller says.
“Either spouse can meet the ownership test,” he said. “You must use the home as your principal residence for two of the last five years.”
4. Mortgage interest deductions. Taxpayers are limited to deducting $1.1 million for acquisition and home equity indebtedness.
Recently, a court allowed unmarried taxpayers who own a home together to each apply the $1.1 million limitation.
5. Deductions related to divorce. Legal fees for divorce aren’t deductible, nor are legal fees related to collecting child support.
But clients can deduct fees related to collecting alimony, tax advice, and the management, conservation or maintenance of property that is held for producing income.
6. Allocation of tax carryovers. In general, the tax code treats marital and individual property differently.
Charitable contribution carryovers are figured by the ratio of amounts that would have carried forward if the couple had filed separate returns in the year of contribution. Capital loss carryovers are based on the individual net losses that created the carryover.
7. Payments after divorce: child support, alimony and life insurance. Child support payments are neither tax deductible nor taxable.
Alimony payments are both tax deductible and taxable, and a recipient may need to pay estimated taxes on alimony. In order for alimony to be tax deductible, it must be required under the divorce or written separation agreement, paid in cash, end at the recipient’s death and not designated as anything other than alimony.
Former spouses must live in different households. Excessively high or front-loaded payments in the first three years after the separation can be taxed.
Life insurance policies are one way to ensure that alimony and child support will continue to be paid even if the payer dies. Premium payments may be deductible as alimony but not if the insured spouse retains policy ownership or the policy is inside an irrevocable life insurance trust.
Support trusts in lieu of alimony are another way to ensure continuing payments. They offer less interaction between former spouses, can protect ownership of closely held family businesses and continue support even after the grantor dies.
They are subject to the rules for trusts, not alimony, so there is no issue around front-loading.
8. Qualified retirement plans in divorce. A qualified domestic relations order can let divorcing spouses roll part of one spouse’s pension plan into an individual retirement account for the other with no tax on the rollover and the early distribution penalty waived.
That doesn’t necessarily mean that a rollover is the right choice. A rollover offers distance from a former spouse, greater control over investments, more beneficiary designation options, the potential to deduct fees and no mandatory withholding.
Staying in the former spouse’s pension plan, on the other hand, can mean fund access for those younger than 59 1/2, possible protection from creditors, loans and/or hardship distributions, and an option to retain life insurance.
“You can leave some money in the ex’s plan and roll over some of it,” Miller says.
There is no time limit on the rollover.
IRA transfers are also not taxable, and they let the recipient name his or her own beneficiaries.
It is crucial to make sure that clients change beneficiary designations for retirement plans, insurance policies and trusts. They should also name new health care agents to make decisions in case they aren’t able to do so.
“I’ve yet to meet a client who says, ‘Yes, I still really love that person and want my ex to get everything,’” Miller said.
“A former spouse can and will get the money if you don’t update beneficiaries,” he said. “This is the diligence we need to provide as advisers to clients in divorce situations.”
This article was originally published at OnWallStreet.com.