Tip of the Month:
Never Use a Pay Stub to Estimate Taxes in Divorce

If you want your assessment of the impact of support to reflect post-divorce reality, tax computations in divorce analysis should not rely on the taxes shown on a pay stub. Taxes shown on a pay stub are almost always significantly overstated when used in divorce analysis. In states where child support is based on the net after-tax income of one or both parents, using pay stub taxes will most likely result in understated child support. The key to understanding this is to realize that taxes will change considerably when the individual gets divorced and taxes usually are lower after divorce in the more typical family situation in which both parties are employed.

Previous Tax Tips have discussed the lowering of post-divorce taxes due to the elimination of the “marriage tax penalty” which means that additional taxes are paid just because married couples are forced to file as Married, Joint instead of two persons who could file as Single. Even if we assume the pay stub taxes are generally consistent with the actual taxes to be paid (a fairly big assumption given the complexity of the IRS W-4 form for establishing tax withholding), the taxes reflected on the pay stub are based on a married filing situation. Tax analysis in divorce must be forward looking reflecting the tax situation post-divorce which will be materially different for most individuals. In addition to using different tax tables (Single & Head of Household), there may be credits available to the divorcing individual which were not available to that person when married. A married couple with joint income of $50,000 may not even know about an Earned Income Credit (EIC) because their joint income was too high to use it pre-divorce. After divorce the custodial parent may be eligible for an EIC of up to $4,000.

Pay stubs based on existing W-4s will not incorporate alimony (maintenance payments) as a deduction for the payer or income to the receiver because amounts will not be known until the divorce or temporary order for support have been completed. Mortgage interest and real estate taxes may not be available after the divorce if the marital home is to be sold.

Finally, pay stub deductions can be manipulated by the individual and can be changed in divorce situations so that the pay stub taxes may not be reflective of the actual taxes to be paid but instead of what an individual would like you to think the taxes are.

Circular E Taxes
Many of you already know all of the above and you may take the time to estimate divorce taxes by applying the tax tables used in the IRS Circular E to the gross income of the divorcing individual. Circular E also has a lot of problems as an estimating tool in divorce. Pay stub tax tables provided in Circular E are available only for the Single and Married, Joint filing status. As show in last month’s Tax Tip, the Head of Household and even Married, filing Separate filing status are important in divorce. The IRS methodology for estimating Head of Household (1 additional deduction allowance – revenue is reduced by $3,050) is only an approximation which is OK at lower income levels and insufficient as income increases. Using this methodology, taxes are off by $100 at $25,000 of income and this minor error increases as income rises – taxes are off by $1,100 at $50,000 of income and $1,800 at $100,000 of income. Finally, you may be able to estimate taxes on regular income based on Circular E but you also need to look at credits which have become very important in divorce analysis. The main credits in divorce are the Child Care Credit, the Under Age 17 Child Tax Credit and the Earned Income Credit. These are more difficult to estimate since some are refundable or partially refundable (get money back even if there is no tax liability) while others can only be used to reduce actual taxes to be paid.

Circular E tax tables are readily available but these tax tables are not the actual tax tables used when tax returns are filed. The Circular E tax tables are designed by the IRS to withhold more tax than is needed so that individuals do not owe money to the IRS when tax returns are filed but instead the IRS will refund extra tax withholding to the individual.

IRS Publication 919 (How Do I Adjust My Tax Withholding?) contains the actual tax tables for the current year and is available at the IRS website. Tax computations using Pub 919 will be more accurate than those using Circular E and should be used by family lawyers to manually compute taxes in divorce analysis. Computer software is available to assist family lawyers who prefer to integrate the tax, alimony and child support computations in one simple package.