The very wise Benjamin Franklin once said, “The only sure things in life are death and taxes.” What Ben could have added is that one of the most unsure things in divorce is the impact of taxes. As couples craft their agreements, they should consider divorce and taxes.
Several general principles can guide couples.
Principle 1—Timing
Couples should generally know that they are either married for the entire year or divorced for the entire year. There are no partial years. Even if the divorce is granted on December 31, spouses are considered divorced for the whole year—and file individual taxes. So, if a couple is considering divorce, they should also consider claiming of deductions and other tax planning early in the year to be ready for filing taxes on their own.
Principle 2—Divorce is not a taxable event of itself
The good news—divorce isn’t, in and of itself, a taxable event. This means that, as couples divide their assets and liabilities, the receiving of marital property doesn’t, by itself, mean that the recipient will pay taxes. For example, if one person receives money out of the other person’s checking account, that isn’t income to be reported on income tax returns. It’s division of property that belongs to both—even if only one person’s name is on the account.
YET—other elements can trigger a need to pay taxes.
Principle 3—You may need to pay taxes if other factors come into play
During the divorce process, couples will need to examine whether they will pay taxes based on factors other than just getting divorced. These can include paying capital gains tax on money from the house, losing the tax credit for 529 contributions, withdrawing funds from investment accounts, or using money received from retirement funds.
Capital gains—Receiving equity from the marital home (whether through selling the home or the other spouse “buying out” the first person’s equity) is not taxable unless the amount of equity received exceeds the capital gains exclusion. Each individual can receive up to $250,000.00 of house equity with no taxes due. However, if a person receives more than $250,000.00 of house equity, they may have to pay capital gains taxes.
So, if one spouse, desiring to keep all of their retirement accounts, offers more money out of the house equity to balance the ledger—the couple should take time to consider whether capital gains taxes are triggered. If so, how does that affect the decisions? It may be better to take only the amount of equity under the capital gains exclusion and then add to that money from other non-taxable accounts such as savings accounts or money markets.
Investment accounts—The same types of factors may come into play with receipt of investment money—e.g. from brokerage accounts. The person receiving should consult with their tax professional to determine whether pulling from these funds to use for everyday life or for downpayment on a house will have tax consequences.
529 credits—If spouses divorce in November of 2025, they will file separate 2025 tax returns in early 2026. On those separate tax returns, only one will be able to claim the tax credit for 529 plan contributions from the prior year. Because joint money is often invested in 529 accounts, discussing how best to use this tax credit should be part of the financial conversation.
Division of retirement accounts—When retirement money, from accounts funded by pre-tax dollars, are rolled from one spouse to another pursuant to the divorce, that generally won’t cause tax consequences. If the funds are rolled into a qualifying retirement account of the recipient, those funds continue to grow tax free.
However, if the recipient desires to use some of that money to put a downpayment on a house or create a nest egg, the person would pay income taxes on any money taken from the retirement funds. Because there are various factors that can limit tax liability and govern timing, it is key to discuss the options with your divorce or tax professional and consider their input into those decisions.
Future sale of received assets—Most agreements state that the person receiving property is responsible for paying any taxes due in the future. So, if a person receives a valuable painting or collection (i.e. tools or gym equipment) then sells that asset, that person will pay the sales tax. Anyone asking for an asset they intend to sell should keep this in mind.
Principle 4—Consider the “divorce tax”
Some attorneys talk about the divorce tax. In doing so they discuss how various accounts carry an inherent loss in value due to the taxes that will come due.
The best example of this would be comparing one person keeping their $500,000.00 Roth 401(K) while the other keeps their $500,000.00 traditional 401(K) funds. The couple may believe this looks even. It’s not.
Because taxes were paid on the money going into the Roth account, the person using those funds does so tax free. The traditional IRA was funded by pre-tax money. So, whenever funds are used, the person will pay taxes. At a 25% tax combined rate for federal and state taxes, that would mean the account would be reduced by $125,000.00 (or actually be worth $375,000.00). When one spouse truly understands the differences in accounts and the other doesn’t, both need to ask questions about tax impact to ensure even is truly even.
According to some attorneys—the best assets, in terms of taxes, are cash accounts, post-tax retirement accounts (such as Roth IRAs or Roth 401(k)s), and health savings accounts (which are funded with pretax money and don’t incur taxes if spent on healthcare). The assets with the highest tax implications are pre-tax retirement accounts and assets with capital gains implications.
To be sure—all assets have value. It is good to have various pots of money to use toward creating financial security for both people. Both will likely need both ready cash to set up separate households and long-term assets to provide for future security. The key is to consider the tax implications for each asset and to find ways to equalize those between the spouses.
Principle 5—Consider tax questions around children
Couples with children will need to consider both which parent receives the child tax credit/s and which is considered the “Head of Household” for tax purposes.
Child tax credit—Parents are usually keenly aware of the federal government’s payment of (currently) $2,200 per child as a direct credit against taxes owed. A hugely valuable tax offering. With all the other financial conversations, parents should consider how to handle the child tax credit.
If the couple has multiple children, a possible solution is splitting the children. For example, if they have 2 children, one parent could claim 1 child and the other parent the other child as dependents. Both parents benefit from a tax credit.
Some reasons NOT to do this. First, if a parent is covering the children on health insurance through the marketplace, it may be required that the parent claim the children for tax purposes. It is important to explore this in advance to understand how eligibility is affected.
Likewise, if a parent obtains health insurance through the Healthy Indiana Plan (HIP) and wants to also cover children, that parent may need to claim the children as dependents. Claiming the children also increases the amount of income the parent can earn and remain on HIP. Parents should check the requirements at the time of the divorce with professionals and discuss what makes the most sense for the family system.
Finally, the child tax credit starts phasing out for parents who earn $200,000.00 per year or more and is completely gone at earnings of $244,000.00. Parents should assign dependents in the best manner to maximize the child tax credit.
Head of Household—When a parent has a child in their care more than fifty percent (50%) of the time, they can claim head of household. This raises the standard deduction for taxes substantially. If parents are evenly sharing parenting, they may be able to rotate this designation if they have one child or split children so both can claim. Parents should consult their divorce or tax professional for clear advice as to how to maximize this resource as well.
As Benjamin Franklin said, taxes are a sure thing. How taxes play out in divorce, however, is anything but sure and has huge complexity. A complexity that can be missed when couples focus merely on who gets which car and getting a quick sale of the house. At Resolution Mediation, LLC, we raise these issues with clients to assure they consider this element along with all others. Whatever process couples use, they need to take time to ask the tax questions. This provides opportunity to ensure the fairest settlement of assets, that both people understand their obligations going forward, and that the most money is kept in the family system.
If you would like more information on navigating all the decisions divorce requires, contact Resolution Mediation by clicking HERE or calling 317-793-0825. We look forward to serving you.
As always, the above is for information only. Seek a professional for guidance in your personal situation. This is an advertisement.
