Choosing to divorce can be the first step toward a happier, more fulfilling life for you and your family—but that doesn’t mean that divorce isn’t challenging. Divorce can feel complex and overwhelming without the right guidance, especially when issues arise that you may have never considered.
One aspect of divorce that surprises many people is that there can be far-reaching tax implications. It’s crucial that divorcing couples think through the possible tax implications when negotiating everything from child custody to division of assets, as these can have a long-term impact on your family’s financial picture.
Knowing what to be on the lookout for can de-stress the divorce process and help plan ahead for your future financial security.
Divorce-Related Tax Concerns in New Jersey
Every state has different tax laws that can impact your tax situation following divorce, and New Jersey is no exception. Together with federal tax implications, it’s essential to know what you’re walking into when making certain agreements or concessions.
If you’re considering or actively pursuing a divorce in New Jersey, there are a number of issues you need to keep in mind. Understanding the potential impact of these topics may allow you to plan for a better tax outlook once your divorce has been finalized.
If you’ve worked with an accountant or tax professional before your divorce, even if you and your spouse shared one, you should get advice from a professional to ensure that you’re fully educated about the options available to you and the choices you’re making.
1. Filing for the Tax Year
Income taxes are based on your marital status on the last day of the tax year (i.e., December 31st).
As soon as you’re divorced, you can’t file as “married” anymore. You’ll need to file as single or head of household even if you’ve been filing jointly all through your marriage. Bear in mind that depending on when your divorce is finalized, your tax withholdings for most of the year may have been based on you filing a joint return.
In this case, you could find that you owe a large amount of federal income tax when you file your tax return. If your divorce negotiations are taking place during the last few months of the year, it’s a good idea to talk to your lawyer and your tax professional about whether it makes sense to wait to finalize your divorce until the start of the next calendar year.
2. Child Tax Credits
In addition to deciding on custody terms, divorcing couples need to determine who will claim each child as a dependent for tax deduction purposes. Based on the current tax laws, a child can only be claimed on one parent’s return, and the tax credit for that child can only apply to the party claiming the child.
Parents may decide that they will share the dependency exemptions and therefore benefit from the tax credits, but this may not be an option if you and your current spouse have an odd number of children, one parent’s income results in the credit being unhelpful to that parent, or a myriad of other situations. It also matters whether both parents can claim Head of Household for any one child based on the rules in Section 504 of the IRS tax code for Divorced and Separated Individuals.
The age differences between children may also mean that one parent continues to receive child tax credits longer than the other. For many couples, alternating who claims dependents each year may be a fair solution.
Working with an experienced family law attorney can help you develop a long-term strategy for addressing these tax issues as related to support. Make sure your attorney has a strong understanding of NJ child support laws so that you and your spouse can reach a fair and equitable arrangement. Make sure your attorney is willing to work with your tax advisor (and vice versa) to ensure everyone is on the same page.
3. Alimony Payments
Under the Tax Cuts and Job Act (TCJA), which took effect in 2019, at the federal level, alimony is no longer tax-deductible for the payor nor taxable to the recipient. This change has simplified the situation for couples reaching a divorce agreement: family law attorneys can now calculate alimony based on the net amount, rather than the gross amount, for tax implications.
4. Property and Other Assets
Future tax consequences of property and other assets are another major consideration.
Most property transfers between spouses during an NJ divorce are tax-free. However, you’ll still need to plan for potential tax implications down the road since tax liabilities could be high if you decide to sell the asset post-divorce.
The amount you’ll need to pay in taxes will be based on the asset’s value when you acquired it, not when your spouse transferred the property to you in your divorce. For real estate, and for some other financial assets, you’ll need to pay capital gains tax on the amount the asset has increased in value between the time you acquired the asset and sold it.
For other financial assets, you won’t see the tax implications (like retirement assets) until after you’re retired since some retirement accounts are tax-deferred. With regard to brokerage accounts holding stocks or mutual funds, you may see different types of tax consequences depending on the types of holdings in the account.
It’s also worth noting that not all assets are treated equally for the purposes of capital gains tax. For instance, there’s an exclusion of $250,000 from capital gains taxes on real property (also known as real estate), provided the property has been your primary place of residence for at least two of the last five years.
This means you’ll pay considerably less tax for property than potentially for other assets. These tax implications are important to consider as you look to obtain a fair distribution of assets—if you’re only looking at the current value of your assets, it may not give you a full picture of the tax consequences associated with them.
5. Retirement Accounts
Retirement accounts are generally considered marital property in New Jersey and, as such, money put into retirement plans while you were married is subject to equitable distribution. This includes any appreciation or loans associated with your account. However, the distribution of retirement assets during a divorce isn’t cut-and-dry.
There are a few factors that play into this. Retirement accounts are highly complex structures. Divorcing couples must contend with different rules for qualified and unqualified plans. Pre-marital contributions and any gains and losses can be excluded, and growth on those portions may need to be categorized separately.
In short, there’s a lot to sift through. To complicate things further, unless the divorcing couple is already in retirement, benefits from accounts aren’t yet being paid out, and withdrawing money from retirement accounts can come with stiff tax penalties.
When navigating their divorce, couples have various options for dividing up their retirement—and dealing with tax implications.
- Immediate offset: Parties exchange assets of equal value for stake in the retirement account. The retirement account must be assessed to determine the present cash value, or tax-adjusted depending on the type of plan and holdings in each plan to provide a “cash or cash-equivalent” exchange. For example, one partner may forgo their right to the other’s workplace retirement plan for equity in the marital home.
- Deferred distribution: The parties agree to defer their shares in retirement accounts until some point in the future.
Depending on the conditions of your divorce, your financial goals, and your relationship with your spouse, you may be required to obtain a Qualified Domestic Relations Order (QDRO) to split qualified retirement assets. A QDRO is a court order that permits retirement assets to be distributed. QDROs can help you avoid some of the tax implications that come with early withdrawals (as long as you roll the money over into an eligible retirement account).
No matter what, it’s essential to work closely with an experienced divorce attorney and a tax professional. Together, they can provide you with guidance to make dividing retirement assets smooth and reduce the risk of tax penalties.
Have Questions? Contact an Experienced NJ Divorce Attorney
Working with a compassionate family law attorney can make the divorce process easier for you and your family—and help you minimize any negative tax consequences from your divorce.
If you have further questions or need help planning for a fair asset distribution during your divorce, contact our experienced team to schedule a strategic planning session.