How a Divorce This Year Will Affect Next Year’s Tax Bill: Five Tax-Intelligent Tips

Susan Copeland, CFP®, CDFA® 
Avantax Senior Financial Planning Analyst

Benjamin Franklin said, “Nothing is certain except death and taxes.” But with the divorce rate for first marriages hovering around 43%, it’s likely only a matter of time before you’ll need to guide a client through this life-altering event.

Below are five tax-intelligent considerations to keep in mind as you guide soon to be divorced clients for next year’s tax return.

Filing Status. If your client’s divorce is finalized by the end of the year (on or before December 31), they can no longer file jointly for that year. In other words, even if your client was married for 364 days of 2024, the return they submit in 2025 (for tax year 2024) will need to be filed as single or head of household (the latter if they have a dependent living with them for more than half the year.) 

Unfortunately, this likely means your client’s income will be taxed at a higher rate than it was in prior years when married, since filing jointly often provides significant tax savings. Be sure your client is prepared for this change.

Timing the sale of the home. It’s no secret that a home is often the largest – and most contentious – asset in a marriage. If your client is awarded the primary residence as part of the divorce and plans to sell the home in short order, ensure you discuss with them the Section 121 exclusion, also known as the principal residence tax exclusion. This tax break can be significant.  

If your client and their soon-to-be ex-spouse can agree on selling the home, it might be more tax advantageous to do so in the year before the divorce is finalized to potentially qualify for the $500k capital gain tax exclusion (only available to those filing jointly). Otherwise, once your client is considered a single tax filer, selling the home will only allow them to qualify for half that amount – up to $250,000 – in capital-gain tax exclusion. This exclusion is not automatic and certain requirements must be met to qualify, regardless of tax filing status. 

Taxable investment accounts. If your client was awarded taxable investment accounts and holds highly appreciated stock, you’ll want to advise them appropriately based on their post-divorce income:

• Assets with built-in capital gains may be better allocated to the spouse with lower income or lower capital-gains tax rates. Otherwise, for any sells made before the divorce is finalized, they may be responsible (along with their ex-spouse) for half of the tax bill on the capital gains from selling that highly appreciated stock – which could be significant depending on the holding period and on their income tax bracket for that year. 
• If your client was the primary earner in the marriage and will remain in a high tax bracket after the divorce, consider advising your client to donate the highly appreciated stock to eliminate capital gains tax. This tax-intelligent strategy would allow your client to take an immediate tax deduction in the amount of the full fair market value (if they itemize their deductions). 

Retirement account withdrawals and transfers. If your client would like to withdraw funds from their IRA to pay their ex-spouse as part of the divorce settlement, they may want to think twice: Those amounts could be taxable and, as a newly single tax filer, they will pay tax at a higher rate. Instead, you can help them make the tax-intelligent choice of transferring retirement assets tax-free from their IRA directly into their spouse’s IRA under a divorce decree through a qualified trustee-to-trustee transfer or a transfer incident to divorce. 

Retirement account contributions. If your client was contributing to their husband/wife’s spousal IRA and their divorce is finalized before year end, your client can no longer deduct those contributions on the following year’s tax return. If your client isn’t in a hurry to get divorced, it might be advantageous to wait to finalize their divorce early the following year, which will allow your client to deduct the maximum amount of those spousal IRA contributions, thus lowering their taxable income.

Additionally, once the divorce is finalized, it’s important to remember your client will now fall under the income limits for IRA contributions based on their new modified adjusted gross income (MAGI) amount and their new tax filing status. Since joint filers usually have higher MAGI limitations than single filers when deducting their IRA contributions, this could impact how much of their IRA contributions they can deduct. 

As always, tax rules are complex, so special care should be taken throughout the divorce process to ensure you’re guiding your client appropriately. To read more about navigating divorce-related financial matters with your clients, check out the main Avantax blog page.