One of the most overlooked aspects of divorce, particularly for parents, is the impact that divorce can have on personal finances. Since one of the benefits of marriage is being able to consolidate living expenses, it makes sense that in most cases, divorced couples experience the opposite—paying more to maintain the same standard of living.
To make things worse, there are many tax benefits that married parents are able to take advantage of. While those tax benefits exist for divorced parents, it’s important to understand what impact a divorce can have on a parent’s ability to claim them.
This article will explore a couple of topics where divorce, parenthood, and taxes intersect.
Child support isn’t really a tax benefit. However, it’s important to understand how taxes work with respect to child support. There are two important things to know about child support:
- Child support is NEVER deductible by the person paying it, and it is NEVER included in taxable income to the person receiving it.
- Payments that might otherwise be considered alimony might be reclassified by the IRS as child support if the IRS determines that those payments are clearly associated with a contingency related to a child. An example would be monthly payments that stop when a child reaches the age of 18.
The last point is important to consider as you negotiate your divorce, because IRS can make these determinations regardless of what is in the divorce decree or any agreements.Not taking this into consideration could have significant tax impacts on both parties. The child support recipient might inadvertently pay taxes on income that the IRS later declares to be child support (and not taxable income) while the payor might not find out until several years later that they owe money to the IRS.
The best way to avoid this is to have your lawyers carefully craft a divorce agreement that accounts for IRS guidelines regarding alimony and child support.
Before we dive into each of the credits, deductions, or exclusions, it’s important to note the concept of transferability. In most cases, only one parent can take advantage of a given tax benefit, even if both parents would otherwise qualify. Generally speaking, that privilege will go to the custodial parent. However, if a tax benefit is transferable, that simply means that the custodial parent is allowed to ‘transfer’ their eligibility to the noncustodial parent.
Why would you choose to do this? Let’s look at a post-divorce family from an ‘overall’ perspective, meaning the combined income of both households. Strictly from a tax perspective, it makes sense for the person who would gain the most after-tax benefit to be able to claim the benefit. Doing this would help to maximize the overall two-household income, which could result in more income being available for both households. In many cases, If the divorce is amicable, this could be a point of negotiation in the divorce settlement.
In such a situation, the custodial parent would file Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent, filing IRS Form 8332 with that year’s tax return. This allows the non-custodial parent to claim the child as a personal exemption on their tax return. While the Tax Cuts and Jobs Act of 2017 reduced the deduction amount of personal exemptions to zero, claiming a child as a personal exemption is how a parent (custodial or noncustodial) qualifies for certain credits. This release can be for:
- 1 year
- A specified number of years
- For all future years
Additionally, parents must have met the following criteria:
- Parents must have been divorced or legally separated under a decree of divorce or separate maintenance, separated under a written separation agreement, or lived apart continuously during the last six months of the calendar year. This includes parents who were never married.
- One or both parents provided more than 50% of the child’s total support for the calendar year.
- One or both parents exercised legal custody of the child for more than 50% of the calendar year.
Transferable benefits include:
- Child tax credit
- Additional child tax credit
- Credit for other dependents
Non-transferable benefits include:
- Earned Income Tax Credit (EITC)
- Dependent care credit
- Exclusions for dependent-related benefits
- Education-related credits
With that said, let’s look into how some of the most common tax benefits might look after a divorce.
Earned Income Tax Credit
Generally speaking, the custodial parent can claim the Earned Income Tax Credit (EITC) for a qualifying child. However, there are a couple of considerations:
- If a divorce results in one or more children living with each parent, both parents might qualify for EITC. However, each child can only be considered one time for the credit.
- If both parents would otherwise qualify for the credit, IRS tiebreaker rules might apply. However, the tiebreaker rules that apply for EITC are not necessarily the same as those that apply for child tax credit or other tax benefits.
- It might be possible to claim EITC with no qualifying child. The IRS website contains guidance on how this might apply.
Transferability: While it might be possible for the non-qualifying parent to claim EITC, it is not transferrable.
Child Tax Credit
Usually, the custodial parent can claim the child tax credit, which increased from $1,000 per qualifying child to $2,000 in 2018.
Transferability: This credit is transferable.
Child & Dependent Care Credit
The child and dependent care credit allows a parent to use up to $3,000 of qualifying child care expenses ($6,000 for two or more children) to lower their tax liability. Depending on the parent’s adjusted gross income (AGI) level, this could amount to a credit of up to $2,100. While it’s not a dollar for dollar credit, the child and dependent care credit can significantly lower a tax bill.
Qualifying child care expenses include:
- Expenses for a child in a school program below the level of kindergarten (pre-K)
- Before or after school care might qualify, as long as they are not directly education-related. For example, after-school enrichment might qualify, but a tutoring program or summer school would not.
- Nursery care
- Boarding school (to the extent that the expenses are directly related for the care of your child, separate from tuition or the cost of education).
Also note that qualifying children must be under the age of 13 for a parent to take the credit.
Transferability: This credit is not transferable. Additionally, the custodial parent still must meet qualifying criteria, such as:
- Having earned income during the year, or paying expenses in order to look for gainful employment.
- Not paying claimed expenses to another dependent (like an older child), spouse, or parent of the child.
- Being able to provide the day care provider’s employer identification number (EIN) on your tax return.
Most importantly, the parent must have actually paid child care expenses in order to qualify for the credit. If the noncustodial parent paid child care expenses as part of the divorce settlement, the custodial parent is not allowed to take the credit.
Exclusion for dependent care benefits
Exclusion for dependent care benefits is different from the Child and Dependent Care Credit in that the exclusion applies to benefits paid for under a qualified employer-sponsored plan. This is known as a dependent care flexible savings account (DCFSA). Here are a couple of things you should know about how this would work:
- The exclusion is only available to people who participate in a DCFSA.
- The most you can exclude for dependent care is $5,000 per year, even if you spent more on child care.
- The exclusion lowers, dollar for dollar, the qualifying expenses of child and dependent care credit that can be claimed. For example, if a parent participates in an FSA that provides up to $1,000 towards child care, then they can only calculate their child and dependent care credit based upon $2,000 in qualifying expenses (or $5,000 for two or more children).
Transferability: This exclusion is not transferable. Only the custodial parent is eligible to exclude child and dependent care expenses under a DCFSA. This is true even if both parents have access to one.
With the ever-rising cost of post-high school education, every dollar counts. It only makes sense to take advantage of every available tax incentive to get the most education for the lowest cost. While divorce doesn’t significantly change this, there are a couple of things worth pointing out:
- For both the American Opportunity Tax Credit and the Lifetime Learning Credit: if a parent is able to claim the qualifying student as an exemption on their tax return, they can claim the credit. However, since the student can often file their own tax return, it is very common for the student to claim the credit themselves. However, only one person can claim a credit for a qualifying student.
- Student loan interest deduction: In order to claim this deduction, a parent must be legally obligated to pay interest on a qualified student loan. In many cases, parents might sign a PLUS loan (Parent Loan for Undergraduate Students). Making payments on a qualifying PLUS loan would be an example of how a parent might be able to deduct student loan interest on their tax return. Simply making student loan payments on their child’s behalf, however, would not.
- Coverdell Education Savings Account (ESA) transfers: Like retirement plan transfers, a Coverdell ESA transfer pursuant to a divorce is not a taxable event. Otherwise, the normal rules for Coverdell ESAs applies.
- Qualified Tuition Programs: Qualified Tuition Programs, also known as 529 plans, are tax-advantaged ways to either prepay college expenses or to contribute to a savings account for the purpose of paying qualified education expenses. In most cases, divorce has little impact on the tax treatment of a 529 plan.
Here is how divorce could impact each of the most widely available education-related tax incentives.
Divorce can be a difficult and financially stressful process. While many people see divorce negotiations as ‘win-lose,’ there are several areas where ‘win-win’ actually exists. When it comes to taxes, there usually are opportunities for both parties to increase their share of the pie.
If you find yourself struggling to make financial sense of your divorce, you should consult with a financial professional that specializes in divorce work. Working with a Certified Divorce Financial Analyst® is a good way to take that first step towards a more financially sound future. Schedule your appointment with Lawrence Financial Planning today. We will always give you professional advice and walk with you every step of the way. We invite you to one of our monthly Divorce Workshops. Find the details on Facebook and Instagram, or visit our website.