The overlooked financial obligations after divorce

Divorce is an emotionally charged experience that impacts over 670,000 American couples every year. It's also a costly process. An uncontested DIY divorce costs between $500 and $1,500 in filing and service fees.

When lawyers get involved, the divorce process alone can cost $50,000 or more. While not every couple will pay as much, the real financial costs only become apparent once legal proceedings are complete.

That's because it's easy to overlook financial obligations that seem insignificant when dividing assets and/or determining child custody. As Alleviate Tax, which specializes in tax relief services, explains below, things like shared tax obligations, changes in tax status, and other critical financial aspects have long-term impacts on life and should not be ignored.

Financial Obligations to Keep in Mind

Through divorce, a unified economic unit (the couple) transforms into two separate households. As a result, life often becomes more expensive since former spouses can no longer share household expenses, pool savings, or take advantage of certain tax benefits.

The financial consequences are not always immediately apparent, but they can create unexpected liabilities. For that reason, it's wise to involve professional financial and tax advice in the divorce process to identify potential liabilities early and provide guidance on managing them.

Here are a few examples of some of the most common financial obligations that couples overlook or underestimate when divorce talks start.

Tax Status Change

One of the biggest financial consequences of divorce is a change in tax status. Taxpayers go from Married Filing Jointly to Single or Head of Household, which can affect their tax brackets, deductions, and eligibility for certain tax benefits.

In a divorce, this change in status becomes clear when deciding to sell the marital home. If the home has $450,000 in equity appreciation, a married couple pays $0 in capital gains tax upon selling. That's because they qualify for a $500,000 capital gains tax exclusion when filing as a family unit.

But an ex-spouse who keeps the home and sells it later only qualifies for a $250,000 exclusion as a single taxpayer. In this case, they will owe capital gains tax on the $200,000 that exceeds their exclusion limit.

Tax Debt Follows Both Spouses

Under federal tax law, both spouses remain 100% on the hook for back taxes, penalties, and interest from any joint return filed while married. If a court orders one ex-spouse to pay past joint tax debt, but that person fails to do so, the IRS will pursue the other ex-spouse for the full balance.

Couples who are still legally married or filed jointly during a separation are both liable if one of the spouses owes past-due individual debts (such as back child support from a prior relationship, defaulted federal student loans, or prior individual tax debts).

If the IRS filed a Notice of Federal Tax Lien against a spouse during marriage, that lien attaches to marital property. In a divorce settlement, that federal tax lien may remain attached to the property's title until the tax debt is resolved.

Retirement Account Transfers

Many divorcees don't know that a poorly handled divorce settlement can affect retirement funds. The most common example comes from the division of employer retirement plans, like a 401(k), 403(b), or traditional pensions.

Unless a prenup states otherwise, retirement contributions made between the wedding day and the date of separation/divorce are legally considered marital property across all 50 states. This means retirement funds are treated as financial assets.

What matters here is how these assets are divided. If a spouse withdraws money from a 401(k) to pay an ex-spouse as part of a divorce settlement, the IRS generally treats the withdrawal as taxable income. A QDRO, or qualified domestic relations order, allows qualifying retirement assets to be transferred to an ex-spouse without triggering the same immediate tax consequences.

While IRAs do not require a QDRO, they do require a strict "trustee-to-trustee direct transfer" specified in the divorce decree to remain tax-free.

Options for a Fresh Start

Untangling merged lives and finances impacts both individuals after a divorce, but there are ways to keep long-term financial obligations to a minimum.  

First, expert financial advice is essential, particularly when the stakes are high. Both soon-to-be ex-spouses should consult tax and personal finance professionals and develop strategies for financial planning and debt management that safeguard their future interests.

Such experts know that the language written into the separation agreement or divorce decree is essential, so they will insist on a comprehensive tax and debt indemnification clause. 

This clause could stipulate clearly defined debt management strategies in case one spouse fails to pay a debt assigned to them (including back taxes). It may also include firm deadlines to deal with co-owned debt, since mortgages and auto loans can remain in both spouses' names even after divorce. 

Protections Against an Ex-Spouse's Tax Problems

The first step in protecting yourself from an ex-spouse's financial and tax problems is knowing what liabilities exist. Identifying potential debts early gives both spouses an opportunity to plan ahead and avoid unpleasant surprises.

During divorce proceedings, both spouses should require complete, sworn financial disclosures covering all liabilities, including pending IRS audits, unpaid taxes, and undisclosed personal loans. This can be particularly important when one spouse has individual debts that could affect a joint tax refund.

If one spouse is not legally responsible for the debt, they may be able to recover their share of the refund by filing Form 8379, Injured Spouse Allocation, with the joint return or afterward. The IRS uses the form to determine each spouse's share of the overpayment and refund the eligible portion to the injured spouse.

Aiming for a Divorce Free of Financial Obligations

The first thing that comes to mind when talking about divorce (especially a contested one) is the division of assets. Each spouse fights for what they consider their fair share of the house, accumulated wealth, properties, etc.

Yet, few couples consider the tax and legal restructuring that accompanies a legal separation. The change in tax status, the back taxes, and the impact on shared retirement accounts are often ignored without proper expert advice. But they don't go away.

This is why preparedness is always the best course of action. Access to up-to-date legal and financial information keeps future ex-spouses aware and ready to act in their best interest.

This story was produced by Alleviate Tax and reviewed and distributed by Stacker.