Hidden Tax Traps in Divorce Your Attorney Won’t Tell You About
Look. Your attorney is doing the best job he or she can. Family law is what they do day in and day out. He or she is just not a tax expert and may not know about all the tax traps in divorce.
If I listed all the things that you (and your attorney) are thinking about, taxes rank low – if at all. Property division, paying alimony or child support, who gets the children, and how will I pay my bills rank well above taxes. That’s a mistake.
Look, it is not you or your attorney’s fault. Taxes are complicated for everyone. Divorce just makes taxes more complicated. Here are just THREE of the biggest tax traps in divorce.
Filing Married Filing Joint Just Because You Feel You Have To
You may want to get a larger refund or perhaps you are going along to get along. Still there is a danger in filing a joint tax return. Any tax debt becomes a joint liability for you both. The IRS can come after you for the full amount of any tax debt, even if you didn’t earn the income that caused the tax debt. And even if you do not have more assets or earn more income than the other spouse. Worse, if your return gets audited because of something your former spouse did – you are still on the hook for the additional taxes.
Additionally, the IRS can seize your assets (in addition to your former spouse’s) to pay a tax debt. If the tax debt is yours, you probably like the fact someone else is on the hook for payment of the taxes. For everyone else, your otherwise protected assets now can be used to pay your former spouse’s tax debt. Are you sure you want to be on the hook for someone else’s taxes?
Perhaps you both have prior years’ tax returns with balances due. So what’s one more year?! Don’t assume that because you are only filing ONE LAST return together that problems can’t arise.
Talk with your own independent tax advisor before filing a joint return, it could save you thousands of dollars and potentially hours of stress and anxiety.
Not Properly Dividing Retirement Plans or IRAs
I could put on a full-day seminar on dividing retirement plans/IRAs in divorce. It is complicated, more so than it should be. You could find yourself in real hot water here. For example:
- Failing to fill out your paperwork to transfer the account over to your former spouse, you are on the hook for any taxes due and not your former spouse.
- Getting the IRA in the divorce rather than a cash settlement mean you will pay the taxes on any later distributions.
- Taking out retirement funds before you turn 59 1/2 could mean penalties on top of any taxes due.
- Using funds from a retirement plan or IRA to pay any marital debt or obligations means you will be on the hook for taxes.
Divide retirement plans and IRAs at your own peril. Trust me, the cost of a meeting with a tax professional is much cheaper than the tax on retirement plan distributions.
Dividing Tax Debts in Divorce Without Considering Federal Law
Leave the best for last. Federal law is supreme. A state divorce judgment does not trump the Internal Revenue Code. If you and your spouse agree to divide the tax debts in a certain fashion, that is not binding on the IRS. A joint return is binding on both taxpayers unless you qualify for innocent spouse relief (discussed in a future post). If your spouse is responsible for the tax debt but you both filed a joint return then the IRS can still pursue you to pay the taxes.
Many a taxpayer has found out after divorce that their agreement to split the tax debts is not worth much against the IRS. You still can sue your former spouse in state court if you pay for their tax debts per the divorce agreement. I don’t need to tell you that likely if the IRS can’t collect any money from the other spouse, you are probably not going to do any better. Adding insult to injury, you are going to have to hire a lawyer to enforce the agreement. Enforcing your agreement can be expensive.
Don’t despair, however, you have options to resolve your joint tax debts. You can read my post here about how to resolve your tax debts. Joint tax debts are dealt with no differently than any debt you incur individually.
The purpose of this post is not to bad mouth family attorneys. I am an attorney and so I respect the hard work they do everyday. Unfortunately, family attorneys focus on “larger issues” but fail to see that taxes can cause you trouble down the road. Nothing can be worse than a bad start to your new life post-divorce. Just a little bit of planning can avoid a lot of headaches.
If you are interested, one of my areas of focus is helping people going through divorce avoid nasty IRS problems. I post blogs weekly on the topic, so come back often. Additionally, I email out a monthly newsletter, A Less Taxing Divorce, which discusses tax problems and divorce. You can find November’s issue here. You can email me at firstname.lastname@example.org if you want to be added to my mailing list.
I am Maine’s IRS Problem Solver. My firm helps Maine taxpayers in trouble. If you or someone you know in Southern Maine wants more information on how to resolve your unpaid taxes, please feel free to contact me directly at 207-502-7181 or by filing out my contact form. A Maine tax attorney can help you consider your options.