In addition to the basic issues of filing status and dependency exemptions, there are some child-related tax issues and spousal support (alimony) considerations to be aware of.
Child-Related Tax Considerations
Head of Household vs. Single Filing Status
There are certain benefits to filing as Head of Household rather than Single. Generally, the tax rate falls somewhere the higher Single status rates and the lower Married Filing Joint rates. To qualify as Head of Household a parent must:
- Be single or legally separated at the end of the year or have not lived with spouse for last six months of the year.
- Pay more than one-half of the costs to maintain the household.
- Have one or more children qualified as a dependent living with them more than one-half of the year (i.e. custodial parent).
With careful planning, Head of Household status can be separated from dependency, and can be split if there are two or more children, as long as each parent has enough income to support a child for more than one-half of the year, and one child lives with each parent more than one-half of the year (> 50% nights). Of course, tax benefits should always take a back seat to a well thought out parenting plan that focuses on what is best for the child/ren.
Child and Dependent Care Tax Credit
The 2014 Child Care Tax Credit ranges from 20-35% of the cost of daycare, depending on Adjusted Gross Income (AGI), up to $3,000 per child, with a maximum of $6,000. It is only available to the custodial parent, so it may be advantageous for the custodial parent to pay the childcare costs directly, even if those costs are eventually shared through support. In order to qualify, the custodial parent must be employed and the child must be under the age of 13.
Earned Income Tax Credit
The earned income tax credit (EITC) may be available to those with earned and investment income below the threshold limits. The 2014 investment income limit is $3,350 and the AGI limit starts at $14,590 with no qualifying children and goes up to $46,997 with three or more qualifying children. The 2014 maximum credit ranges from $496 with no children and $6,143 with three or more children.
Generally the custodial parent may claim them EITC because of the requirement that a qualifying child live with the parent for more than onehalf of the year (> 50% nights). The parents can only alternate the EITC each year if they change the actual parenting plan and who has physical custody.
For those with older children already in, or approaching, college, the parent who claims the dependency exemption is the one who may claim the American Opportunity Credit (up to $2,500/year) or Lifetime Learning Credit ($2,000/year). So, it may be a good idea to specify in the divorce agreement that the parent paying tuition gets the dependency exemption for a given year(s).
Spousal Support (Alimony) vs. Child Support
Spousal support is taxable to the payee, and deductible for the payor. Child support is not tax deductible for the payor. Because the payee often has less income, it can make sense to structure the family support in a way that reduces the overall tax implications.
In order to prevent people from disguising child support or property settlements as spousal support in order to take advantage of a lower tax bracket, the IRS created recapture rules (child-related contingency rules and excess spousal support limits) that must be carefully considered when the settlement agreement is created.
The IRS also has requirements regarding payment of spousal support in order for it to qualify as tax deductible for the payor. Some things to be aware of:
- It must be paid in cash or equivalent. The transfer of services or property does not qualify.
- The payments must be written into a separation agreement or court order.
- If the amount is changed, there must be a modification to the order.
- Parties must not be members of the same household (unless for temporary maintenance).
In the rare case where it may be beneficial to have the support included in the payor’s gross income, rather than the payee’s, a written agreement to do so must be included in the divorce agreement. A copy of the instrument must then be attached to the payee’s tax return for each applicable year.
Both parties, if employed, should be sure to update their federal withholding elections on Form W-4. For those paying deductible spousal support, an additional exemption may be claimed for roughly every $3,800 being paid. Those receiving spousal support may want to consider having extra taxes withheld or make quarterly estimated tax payments to reduce the future tax burden.