We’ve all heard the old adage that “there’s nothing certain in life but death and taxes” and maybe that’s why, when it comes to divorce, so many people are surprised at what effect a divorce can have on those two seemingly unmovable certainties. Everything else in divorce is so up in the air and seems so much more important, that the effect divorce can have on what you leave for your loved ones and what the government will take often gets moved way down on the priority list of concerns. However, in the interest of leaving no stone unturned, it’s important to consider the effects that divorce can have on estate planning and tax planning.
Many states have laws that will prevent an ex-spouse from collecting as a designated beneficiary following divorce. In these states, generally any part of a will, life insurance policy, or retirement plan favoring your former spouse is considered null and void upon entry of the divorce, eliminating your ex’s ability to benefit from your death. Other states; however, do not have this statutory protection or it is more limited.
Even when the law provides protections for the deceased, there are usually limitations to that safety. For example, if you remarry your former spouse, their right to inherit is often reinstated. Also, most statutes require that for the estate to be protected the divorce must be final. In the event you should die while the case is pending, your spouse would still be able to collect in most jurisdictions. While that may seem an easy fix in that you could just change your will or designated beneficiary during the divorce, it might not be that simple. Many courts enjoin parties from changing beneficiaries on accounts or policies during the pendency of the divorce case. Consequently, depending on how your State approaches this, it may be wise to change your will before you file for divorce.
Child support and alimony or spousal maintenance are other considerations that you may need to think about in planning for the possibility of your untimely demise. Some courts require that child support be an obligation of the estate after death or that a parent get a life insurance policy benefitting their children to be certain the children’s needs are met in case of the parent’s death. While some states have a statutory mandate that child support be an obligation of the estate, other states provide no such protection for children at all. Alimony or spousal maintenance may also have statutory protection in some states. Regardless of what your state’s law requires, if it is important that support be an obligation of the estate, the best method is just to include language in the divorce decree ordering that obligation.
Spousal maintenance or alimony may also have unexpected tax consequences on the payor and the payee. If all of the requirements are met for alimony under the federal tax code, the payor can take the alimony as a deduction, while the payee has to claim it as income. Oddly enough, one of these requirements is that the payments will cease upon the death of the payee. The other requirements are that the payments must be received by, or on behalf of, a spouse under a divorce or separation instrument; the divorce or separation instrument cannot designate the payment as a payment which shall not be included as gross income for the payee or not allowable as a deduction for the payor; and the payor and payee are not members of the same household at the time the payment is made.
While an entire book could be written on the effects of divorce on taxes, a basic knowledge of tax issues is important for piece of mind both during and after the divorce. For example, it is important to be aware that the IRS will award the deduction for child dependants to the parent who has had possession of the children the most time out of the past year, not to the parent paying child support. However, this can be changed by written order. Therefore, it is best to specifically address who will receive the deductions on the children in the divorce decree so that there is no confusion or possible penalties at tax time.
It is also important to be aware that the parties must file separately in the year that they are divorced. However, the decree will need to specifically address how income made or deductions created prior to the entry of the divorce will be handled in each party’s tax return. Additionally, the language in the decree should address how any returns or liabilities will be handled for years during the parties’ marriage.
Although many people skip through this section of the divorce decree when reviewing it prior to entry, thinking it all just standard language, it is a mistake not to look more closely. Not understanding how taxes will be addressed in future years or in the event of an audit could bring dire financial consequences for one party or both.
The few points addressed here are just the tip of the iceberg when discussing all of the issues and effects that divorce may have on death and taxes. The real lesson to be learned is that these two areas should not just be cast off into the realm of the inevitable and unimportant. Knowing your rights and seeking advice of counsel on what the government and your beneficiaries will get in the future is crucial. It may mean the difference between financial ruin or financial success because, while death and taxes may be certain, the effect those life events have on you and your loved ones is very uncertain.