By Dan Reiter, CFP®, CPA, CDFA
Divorce is a deeply personal and often turbulent experience. It's easy to get caught up in the legal and emotional complexities of the situation 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.
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 The price, however, is a full tax burden when dollars are withdrawn from the account.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 Accounts: Examples are both Roth IRAs as well as any Roth balance within a 401(k). These work the opposite way from pre-tax retirement accounts. Deposits made to 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 not within a retirement account. You may pay capital gains taxes when you sell these assets. The "cost basis" – what you originally paid for them – plays a huge role. Note that the marital home fits this category, but certain tax breaks may apply to a portion of the gain. Given the nuance to such rules surrounding taxation of the marital home, however, it is important to specifically understand how to plan for the marital home in divorce.
Cash: Savings, money market, checking, and CDs are just a few examples of cash. Generally, there are minimal tax consequences when withdrawing from these accounts.
Where the “illusion of fairness” comes in is when deciding how to divide the assets. They may be divided equally based on the balances shown on the statement. However, 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!
Note that not all examples are quite this simple. It is important to 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
In situations where there are dependent children and custody is shared, one common practice is to either divide the dependents (one spouse gets one child, the other gets the other, etc.) or alternate years each spouse gets to claim the child(ren) as dependents. However, it should be considered 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, there are tax credits available to help offset the costs. The American Opportunity Credit, generally for those 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 that are still supporting graduate students, another credit worth $2,000 is available if more than $10,000 in education expense are paid. Neither education credit is allowed, though, for single filers with gross incomes above $90,000 (in 2025).
A common theme you likely noticed is that 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. If the common practice of alternating or dividing the children being claimed is implemented, the credits the spouses receive collectively may be less.
Mistake # 3. Failing to Plan if Withdrawals from Retirement Accounts are Needed Before Age 59.5
Divorce often requires a significant financial shift. 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 need to withdraw from retirement accounts before you turn 59.5, there are ways to structure the distribution to avoid the extra 10% penalty cost:
Distribution from a Qualified Plan to an “Alternate Payee” Pursuant to a “Qualified Domestic Relations Order” (QDRO): To understand this, first we must simplify the legalese. First, a qualified plan is a type of retirement account. Examples include most workplace plans, including 401(k)s. They do not, however, include IRAs. When qualified plans are divided as part of a divorce, a document must be executed by the court called a Qualified Domestic Relations Order. “Alternate payee” simply means 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. These are generally a good option if a certain amount of fixed income is needed on an ongoing basis.
To qualify generally, “substantially equal” payments must be made from the retirement account not less frequently than 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. Depending on whether it is a qualified plan or an IRA, there are other certain exceptions to the early withdrawal penalty. For IRAs only, common examples are qualified higher education expenses and up to $10,000 for first-time homebuyers. A terminal illness or disability exception also applies to most plans.
Mistake # 4. Filing Separately? It Might Cost You More
Filing taxes separately might seem like the simplest solution, but it can cost you more. A couple of common examples follow:
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. Don't Forget About Your Taxes From This Year: Divide the 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 31st, you must still file as married. Meanwhile, tax payments continue to be paid by both spouses.
If you're getting divorced before your final married return has been filed, refund received, or final tax liability paid – you should have a clear agreement in place on how to handle any tax refund or any taxes owed. This will prevent arguments and potential financial hardship down the line.
Conclusion
In conclusion, 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.
Investment advice, financial planning, and retirement plan services are provided by Prosperity Planning, Inc., an SEC registered investment advisor. The information contained herein, including but not limited to research, market valuations, calculations, estimates and other material obtained from these sources are believed to be reliable. However, Prosperity Planning, Inc. does not warrant its accuracy or completeness. The information contained herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or to participate in any trading strategy. If an offer of securities is made, it will be under a definitive investment management agreement prepared on behalf of Prosperity which contains material information not contained herein and which supersedes this information in its entirety. Any investment involves significant risk, including a complete loss of capital and conflicts of interest. The applicable definitive investment management agreement and Form ADV Part 2A will contain a more thorough discussion of risk and conflict, which should be carefully reviewed before making any investment decision.
