Tax Implications of Divorce

Divorce means the end of not just a romantic relationship but also a financial one. Couples going their separate ways must divide assets that have accumulated and appreciated over years, if not decades—and that can come with big tax consequences.

"It can be very difficult to remain levelheaded and practical during what's often a highly emotional process," says Susan Hirshman, director of wealth management for Schwab Wealth Advisory and the Schwab Center for Financial Research. "However, as clinical as it may sound, prioritizing tax efficiency can ensure that both of you retain as much of your wealth as possible—a true win-win."

Tax consequences are especially important if the situation turns adversarial. If you're arguing over assets, knowing how they'll be treated for tax purposes may help you assess their true value. "You should go into the process educated, prepared, and purposeful," Susan says.

Here are some guidelines on the best ways to divide your marital assets—and what your newly single status means going forward.

The division of your assets will depend on any pre- or postnuptial agreements you may have, as well as the state you live in:

• In most U.S. states, judges must split a couple's assets and earnings accumulated during the marriage equitably—though not necessarily equally. Factors determining who gets what include the length of the marriage, each person's income and earning potential, their contributions to the marriage, and whether one spouse was at fault for the divorce. "The court has considerable discretion in how things are ultimately divided," Susan says.
• In the nine community property states—Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin—earnings during the marriage and any assets acquired with those earnings are generally split 50/50.

"When negotiating a divorce settlement, you should group assets by type and assess their values from an after-tax perspective since tax rates vary according to the kind of account or asset," Susan says. For example:

"There are no tax implications for transferring even large amounts of cash between spouses," says Austin Jarvis, director of estate, trust, and high-net-worth tax at the Schwab Center for Financial Research. "What's more, as long as the transfers comply with the divorce decree, there is no gift tax owed even if the money is distributed after the divorce is final."

If the home is jointly owned and the sale triggers capital gains, each spouse is eligible for a $250,000 tax exemption on their share of the gain ($500,000 if they file jointly). However, to qualify for the exemption, you must show that the home has been your primary residence for two of the past five years. "If the couple has lived separately for an extended period of time and is just now finalizing their divorce, one person may not be eligible for the exemption," Austin says.

You can avoid this potential pitfall with a separation agreement or divorce decree that stipulates the nonresident spouse retains an ownership share of the home. "In this scenario, both are eligible for the exemption—as long as one spouse continues to make the home their primary residence," Austin says.

The true value of a brokerage account depends largely on how long the assets have been held and how much they've appreciated or depreciated. "Two accounts of the same value can have substantially different tax outcomes when sold, based on how much you originally paid for the underlying assets and when," Austin says.

Gains on assets held one year or less will be taxed as ordinary income (up to 37%), while assets held longer than a year are taxed at long-term capital gains tax rates of 0%, 15%, or 20%, depending on your income, and may be subject to an additional 3.8% net investment income tax if your modified adjusted gross income is above certain thresholds. "If you evenly split a portfolio between two spouses but one earns substantially more than the other, the higher-earning spouse could wind up with a lower after-tax value," Austin says. "Whereas if you're able to strategically divvy up assets, you could walk away on a more even footing."

If you evenly split a portfolio between two spouses, the higher-earning spouse could wind up with a lower after-tax value.

24% income tax bracket, 15% capital gains tax bracket

After-tax value: $465,400

35% income tax bracket, 23.8% capital gains tax bracket

After-tax value: $452,200

You should also pay close attention to depreciated assets, since whoever owns them can sell them at a loss to offset capital gains and/or ordinary income. "This often gets overlooked, but in a divorce proceeding those losses can be beneficial to either party, depending on their situation," Austin says.

Even though 401(k)s, IRAs, and pensions are individually held, any funds accumulated during the marriage are nevertheless considered marital property. As a result, a spouse with greater overall retirement assets may need to transfer some of those funds to the other spouse's retirement account according to specific rules:

• 401(k)s: Funds being transferred from a 401(k)will require a separate court order, called a Qualified Domestic Relations Order (QDRO). "The assets are transferred from one account to the other like any rollover, and they will continue to grow in the new owner's name as if they were theirs from the beginning," Austin says. (You can also receive the funds via check, but you must deposit it within 60 days to avoid a 10% early withdrawal penalty if you are younger than 59½.) If you wish to cash out a portion of the proceeds and are younger than 59½, you can take a one-time distribution without paying the penalty—although such funds are subject to withholding and taxed as ordinary income.
• IRAs: An IRA can be divided without tax consequences as long as it's spelled out in the divorce decree. But any subsequent withdrawals before the age of 59½ are subject to an early-withdrawal penalty.
• Pensions: A pension benefit earned during your marriage is typically considered joint marital property. (Conversely, if some of the benefit was earned prior to your marriage, it is generally considered separate, nonmarital property.) Any joint value is typically divided in one of two ways. The spouses can agree to share the monthly annuity payments during retirement, as spelled out in a divorce decree. If you are awarded a share of your spouse's pension, you'll generally need to present the plan's administrator with a QDRO, as you would with a 401(k). Alternatively, you can calculate the present value of the pension at the time of the divorce. The spouse with the pension would then transfer assets of equivalent value and maintain the pension for themselves.

Art and other collectibles acquired during the marriage will also have to be divvied up. (Gifts are an exception; generally, those remain the property of the recipient.) The cost basis of such items is the original purchase price, so consider how much they've appreciated and what the capital gains tax implications might be.

A business is often seen as marital property and will likely be divided according to your state's equitable distribution or community property laws in one of two ways:

• The business can be sold outright and the proceeds disbursed as one would any other financial asset, with the proceeds subject to all the resulting taxes.
• One spouse can buy out the other spouse either in cash or in assets of equal value. Agreeing on the value of the business, however, can be tricky. The selling spouse will likely owe taxes on any capital gains, which could diminish the overall value of the asset. If you're the buyer, on the other hand, your cost basis for the business will be stepped up based on the valuation at the time of the buyout, which could enhance the overall value of the business in the future.

"Valuing and selling a business, and then figuring out the tax implications, can be especially complex," Austin says. "It should be approached with an appropriate team of specialists."

A revocable or living trust can be modified or dissolved, and the assets divided. However, irrevocable trusts cannot be changed, even in the case of divorce. If a spouse is receiving income from an irrevocable trust, that income can generally be considered in a divorce proceeding for spousal or child support purposes.

For divorces granted before 2019, alimony payments are taxable for the recipient—and tax-deductible for the payer. For divorces granted or modified in 2019 or later, they're neither taxable for the recipient nor deductible for the payer. Child support payments, on the other hand, aren't considered taxable income no matter the timing of the divorce decree.

Your filing status depends entirely on whether you are legally married on the last day of the tax year:

• If you're legally separated or divorced on December 31, you must file as single for that year no matter when the divorce was finalized during the year.
• If you're living apart but not legally separated or divorced, you are still married in the eyes of the IRS, and you can choose whether to file jointly or separately. "Joint filing is often more advantageous to both parties but hinges on having a good enough relationship with your soon-to-be ex that you can coordinate your tax preparation," Austin says.

If you have a child, the custodial parent—the one in whose home the child spends the majority of the days of the year—is generally eligible to file as head of household, which comes with a higher standard deduction ($21,900, versus $14,600 for a single, non-head-of-household filer in 2024).

Even in equal custody arrangements, one parent almost inevitably houses the child or children more frequently than the other—even if it's only by a single night—thereby establishing primary custody. In instances where there is more than one child, both parents may be eligible to file as head of household, provided each has a child living with them a majority of the days of the year.

The custodial parent is also the parent eligible for the Child Tax Credit (CTC), the Additional Child Tax Credit (ACTC), and other credits, where applicable. However, as part of the divorce decree, parents can agree to switch off claiming the credit—or the noncustodial parent can be awarded the credit each year, though the custodial parent will need to fill out IRS Form 8332 every tax year in which their ex will claim the credit.

Both parents, regardless of their custody status, may be able to deduct their portion of any qualifying medical and dental bills for their child if their total medical expenses exceed 7.5% of their adjusted gross income.

Once you're officially divorced, you'll need to update your filing status with your employer within 10 days using Form W-4. You'll also want to review your withholding based on your income and new filing status. And if you change your name, make sure to report it to both the Social Security Administration and your employer before you file your taxes to prevent any delay in your tax refund.

It might also make sense to work with a tax advisor to better understand your new tax status. "Unfortunately, single filers often face higher tax rates than married couples," Susan says. "But a qualified tax professional can help you optimize your withholding and think through other strategies that may allow you to keep more of your money in your pocket."