The Gray Divorce Podcast: Episode 53 Beware of Taxes in Divorce!
In this episode of the Gray Divorce Podcast, Andrew talks about the tax effect on divorce settlement agreements. While divorce settlements are generally not taxable events, the sale of property following the divorce may trigger taxes.
It's important to be aware of this tax effect so that you emerge from divorce with the settlement you thought you were getting.
Cost basis is an important issue. If you emerge from the divorce settlement with assets that have a low-cost basis, meaning that they have a lot of unrealized gains in them, you could end up paying substantial capital gains taxes when you sell these assets.
Personal Residence
Many of you may be aware that married couples filing jointly may be eligible for the primary residence exclusion of up to $500,000 in capital gains if they meet the ownership and use requirements as established by IRS tax laws. That capital gains exclusion is $250,000 for a single person. To qualify you must have owned the home for two years and lived in the home for two of the past five years.
So, it's important that the sale of the home be timed so that both spouses can maximize this exclusion. This is particularly important if you're the homeowner keeping the house after divorce. You may find that when you ultimately do sell the home you end up paying more than you thought you would in taxes, and you don't get as much money out of the divorce as you thought you would in the settlement.
Investment Accounts
Let's say a couple splitting is a $200,000 regular brokerage account. And in that brokerage account, there are some shares of Apple stock that were purchased 20 years ago. And let's say there is also a bond fund that was purchased four years ago. For simplicity's sake let's say that both the apple stock and the bond fund are worth $100,000. And let's say, hypothetically in splitting this account one spouse gets the apple stock and the other spouse gets the bond fund. Well, it's very likely that that Apple stock has a very low-cost basis with a lot of unrealized gains built into it while the bond fund is likely to have far smaller gains, a higher cost basis, and may even have unrealized losses associated with it. There may be a scenario where the Apple stock that's worth $100,000 was purchased for $10,000 many years ago but the bond fund may have been purchased for $110,000. Both assets are worth $100,000 today but when they're sold sometime down the road the tax implications will be very different. With the Apple stock, the seller will be paying substantial long-term capital gains taxes while with the bond fund the seller may actually realize a tax loss to offset against other possible gains.
Retirement Accounts
Well as many of you know, particularly those of you who are taking required minimum distributions from your retirement accounts, the sale of investments inside the account isn't taxed, the taxation comes when you take money out of the account. When you make a withdrawal. And, as I just mentioned, the IRS wants to take a nibble at these accounts later in your life and that's why the IRS mandates required minimum distributions or RMDs. Your first RMD must be taken by April first of the year after you turn 73. Subsequent RMDs must be taken by December 31st of each year.
Now if we consider a Roth IRA, when we made contributions to the Roth we didn't get a tax break. But that means that when we take money out of a Roth subject to certain conditions we aren't taxed in those withdrawals. So, if you're splitting assets in a divorce case and you have the option of keeping $400,000 in a Traditional IRA or $400,000 in a Roth IRA, you typically want the Roth IRA money because you're not going to be subject to taxes on withdrawal down the road.
Similarly, even $100,000 in a regular bank checking account is worth more in a divorce settlement on an after-tax basis than a Traditional IRA or a 401K because you're not taxed at your ordinary income tax rate when you take money out of your bank account.
When a 401K is split pursuant to a QDRO in divorce the person receiving part of their ex's 401K (that person is typically called the alternate payee) will have an account set up at the 401K plan of their soon-to-be ex-spouse. In most cases, the alternate payee won't want to leave those assets in their ex-spouse’s company's 401K even if they are in their name now. They'll often choose to roll those assets into their own IRA. Once again because this is divorce there's no taxation on that transfer of assets from the alternate payee 401K to the IRA. The issue that comes up is if you, the alternate payee, needs some of that 401K money you're getting for immediate expenses. If you're under age 59 1/2 you need to be careful. Rolling those retirement funds into an IRA and then taking a distribution will subject you to a 10% early withdrawal penalty. It's important to know that the IRS allows you to take money from this alternate payee 401K that's been set up for you without a 10% early withdrawal penalty if you take it directly from that 401K plan you've been awarded pursuant to the QDRO before rolling it into the IRA. Of course, you're still going to need to pay income taxes on the distribution and the 401K company will withhold some of those taxes. So, there's a lot of planning that goes into this sort of thing. I deal with these situations with clients all the time. If you have any questions, please feel free to give me a call.
Tax Filing Status
Another issue to consider is your tax filing status. It's important to know that your tax filing status for the year is determined by your marital status on December 31st of that year. So, it doesn't matter if you were married all year and got divorced on December 22nd. If your divorce is final before the end of the year you cannot file jointly and enjoy the typically preferential tax rates of married filing jointly.
This is where it's important to plan the timing of your divorce. You may be able to take advantage of the most beneficial filing status. In many cases, the difference you'd pay in taxes between filing single or filing jointly may be enough to cause you to change the anticipated date of divorce from the end of the calendar year to January of the next year. Of course, every situation is unique, and you need to consult your divorce financial advisor, your tax specialist, and/or your attorney to see if such a strategy makes sense for you. Remember, filing jointly means sharing liability for any taxes owed and you may find that your soon-to-be ex has an unusual or complicated financial situation or maybe they've made some questionable deductions. In that case, it may be safer for you to file separately.