By Dan Reiter, CFP®, CPA, CDFA

It's easy to get caught up in the legal and emotional complexities of a divorce and overlook the significant financial implications, especially when it comes to taxes.

We have seen many couples make these mistakes during their divorce, so we want to share them with you so you can avoid the same pitfalls.

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Mistake # 1. The Illusion of Fairness: Ignoring Taxes When Dividing Assets

It's natural to want to divide everything equally, but when it comes to assets, "equal" doesn't always mean "fair." Not all assets are created equal from a tax standpoint. Some assets come with a future tax burden attached. As such, only looking at total dollars in an account when dividing assets may result in a lopsided economic outcome. Below are a few different types of assets and how to potentially consider each one:

• Pre-Tax Retirement Accounts: Most retirement accounts are “tax deferred,” meaning deposits into and growth within these accounts are shielded from taxes today. The price for such benefit, however, is a full tax burden when dollars are withdrawn from the account. These most commonly include any standard IRAs and pre-tax 401(k) balances.
• Roth Retirement Accounts: Examples are both Roth IRAs and any Roth balance within a workplace 401(k). These work the opposite way from pre-tax retirement accounts. Deposits made into the accounts are not deducted from taxable income. However, withdrawals made down the road are free from tax.
• Non-Retirement Accounts: Think about the stocks, bonds, or real estate you're dividing in your non-retirement investment portfolio. You may pay capital gains taxes when you sell these assets if the "cost basis"—what you originally paid for them—is less than you receive in the final sale. The marital home fits this category, but certain tax breaks may apply to a portion of that gain, as discussed earlier.
• Cash: Savings, money market, and checking accounts and CDs are just a few examples of cash. Generally, there are minimal tax consequences when withdrawing from these accounts.

The “illusion of fairness” appears if attempting to divide these assets equally based on the balances shown on the statement. The statement balance isn’t the whole story. Let’s say one spouse receives a retirement account of $250,000, while the other receives an equal amount of cash. If the spouse that received the retirement account is subject to 25% tax, the true spending power from that account is $187,500. There is a $62,500 liability to Uncle Sam in the future. The cash receiving spouse, though, gets to spend the full $250,000. It’s equal, but sure isn’t fair!

Not all examples are quite this simple, though it illustrates a key principle: Estimate the potential tax liability attached to all your assets when negotiating your separation agreement.

Mistake # 2. Failing to Consider the Tax Benefits of Dependents on Both Sides

When a divorce involves dependent children and shared custody, agreeing on who receives the tax benefit of the dependents becomes important. One common practice is to split the benefit: one spouse gets one child, the other gets the other. Another option is to alternate the years each spouse gets to claim the child(ren) as dependents. That said, consider whether the tax benefits of claiming the children are the same for both spouses. In cases where one spouse earns a significantly higher income, this may not be the case.

Here are some of the most common tax benefits only afforded to the spouse that claims the dependent(s):

• The Child Tax Credit: This credit can reduce your tax bill by $2,000 for each qualifying child under the age of 17. However, the full credit is only allowed for single filers that make less than $200,000 per year (in 2025).
• Education Credits: If your kids are in college, tax credits can help offset the costs. The American Opportunity Credit, which applies to students in their first four years of college, is worth a maximum amount of $2,500 if at least $4,000 of qualifying education expenses are paid for each student. For parents who are still supporting graduate students, another credit worth $2,000 is available if more than $10,000 in education expenses are paid. Neither education credit is allowed, though, for single tax filers with gross incomes above $90,000 (in 2025).

As you can see, there are income limitations to some of the most valuable benefits to claiming a dependent. As such, it is not uncommon for the tax benefit to be significantly higher for one spouse than another.

Mistake # 3. Failing to Plan for Early Retirement Withdrawals, If Needed

Divorce often requires a significant financial shift, and you might need access to retirement funds to cover living expenses, pay off debts, or start over. But withdrawing from your retirement accounts before you're 59 ½ usually comes with a hefty 10% penalty.

If there is no way to avoid the withdrawing from retirement accounts before you turn 59.5, you can structure the distribution to avoid the extra 10% penalty cost:

• Distribution from a Qualified Plan to an “Alternate Payee” Via a “Qualified Domestic Relations Order” (QDRO): A qualified plan is a type of retirement account that includes most workplace plans, including 401(k)s. They do not, however, include IRAs. When qualified plans such as a 401(k) are divided as part of a divorce, a document must be executed by the court called a Qualified Domestic Relations Order. An “alternate payee” is simply a payee other than the owner of the plan.

Distributions from qualified plans subject to a QDRO are free from the 10% penalty. However, mistakes are common here. First, the distribution from the plan must be made after the QDRO is processed and before the account is retitled into the new owner spouse’s name. As such, these are typically used for one-time distributions needed for immediate liquidity needs such as paying off debts.

Need a larger lump sum distribution? Consider requesting a portion of your spouse’s 401(k) as part of the separation agreement. However, you should work with a financial professional that understands the correct order of operations and how to work through the QDRO process.

• The 72(t) Rule: This exception to the 10% penalty on early withdrawals allows you to withdraw from your retirement account over a specific period, but it has strict requirements. This is generally a good option if a certain amount of fixed income is needed on an ongoing basis and the only viable option is a retirement account.

To qualify generally, “substantially equal” payments must be made from the retirement account at least annually, be calculated based upon the life expectancy of the recipient and be made for a minimum of five years. The calculation and structure of such distribution can be complex, so we highly recommend working with a professional if this type of distribution is needed.

• Other General Exceptions. For IRAs only, qualified higher education expenses and up to $10,000 for first-time homebuyers are other exceptions available. A terminal illness or disability exception also applies to most plans.

Mistake # 4. Filing Taxes Separately

Filing taxes separately before your divorce is finalized might seem like the simplest solution, but it can cost you more:

• Certain Tax Credits Are Disallowed: Many valuable credits, like the Child and Dependent Care Credit and the education credits, are either reduced or completely unavailable when you file separately.
• Retirement Contributions Could Be Limited: Your ability to contribute to certain retirement accounts, like Roth IRAs, may be restricted if you file separately.

Mistake # 5. Not Dividing This Year’s Refund (Or the Bill) Fairly

Even if you're separated, you're still legally married for tax purposes until your divorce is finalized. If you were separated before year-end but still legally married as of December 31^st, you must still file as married. Meanwhile, tax payments should continue to be paid by both spouses.

If you're getting divorced before your final married return has been filed, you should have a clear agreement in place on how to handle any tax refund or any taxes owed. This can prevent arguments and potential financial hardship down the line.

Divorce is a complex process with significant financial implications. By understanding the tax consequences of your decisions, you can make more informed choices and potentially save yourself a considerable amount of money. Remember to consult with a qualified tax professional and divorce attorney to ensure that your settlement addresses your unique tax situation and protects your financial future.

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