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Pursuit of Your Best Self Tip #7

Pursuit of Your Best Self Tip #7

March 26, 2024

When dividing assets during a divorce, think about the long-term consequences of the assets you ask for. They might have tax implications! 

Tip #7: Consider Long-Term Consequences When Dividing Marital Property

First, it’s important for us to know what marital property is. In a nutshell, marital property is all income and assets acquired by either spouse during the marriage. This includes – but is not limited to – 401(k)s, other employer retirement plans, Traditional IRAs, and ROTH IRAs. It also includes property that you might not necessarily think about, such as deferred compensation, stock options, restricted stocks and commissions, country club memberships, annuities, life insurance, brokerage and bank accounts, real estate, cars, boats, art, antiques, and tax refunds (Garofalo Law Group: The Long Term Asset Issue).

Many times, the tax implications of the marital property being divided get overlooked. I cannot stress enough the importance of considering tax implications before you go to the proverbial negotiating table. Below are some important points and examples:

  • Property transfers incident to divorce from one spouse to the other generally will not result in taxable gain or loss. However, divorcing couples should be aware of requirements in the IRS Code that make a transfer considered as ‘incident to divorce.’
  • Alimony prior to December 31st, 2018, was taxable to the recipient and tax-deductible by the payor. For divorcees finalized starting January 1st, 2019, through December 31st, 2025, alimony is not taxable to the recipient and therefore not deductible by the payor. We can thank the Tax Cuts and Jobs Act (TCJA) for this change. However, this change may only be temporary. The TCJA is set to expire on December 31st, 2025. So only time will tell the fate of alimony payments and their taxability.

Be extra careful when it gets to the portion of your spouse’s employer retirement plan because this is a tax deferred asset. What this means is that no tax has been paid on this money. Therefore, when money is disbursed or withdrawn, that tax will be owed. The tax owed could be Federal or State (depending on which state you live in), and the money can potentially be subject to an Early Withdraw Penalty of 10% (this comes into play if you are under 59 ½).

For example, in the state of Georgia, if you were to get a portion of your spouse’s 401k plan and you took it in cash, then you would owe Federal tax (let’s estimate 22%), Georgia state tax of 6%, and an Early Withdraw Penalty of 10% for a total of 38% being paid in taxes. RED ALERT.

Qualified Domestic Relations Order

To avoid all these taxes and penalties, you must have a QDRO in place at the time your divorce papers are signed. What is a QDRO? It’s a Qualified Domestic Relations Order which basically states that you are to receive whatever portion agreed upon in the same manner it is currently held (i.e., tax- deferred). This will require you to open a Traditional IRA and move the money over as a custodial transfer. What this means is that the check is not made out to you. It is made out to the custodian (or the brokerage firm, bank, etc.) that is going to hold your IRA for you. This is huge. It’s necessary to prevent a sizeable amount of your asset going straight to Uncle Sam.

Investment Accounts

Investment accounts often get overlooked as well. I always explain the taxation of investment accounts to my clients as the bucket of your assets that you are “keeping up with the taxes on an annual basis.” What I mean by this is, investment accounts may have many holdings in them, such as stocks, mutual funds, and exchange traded funds. The holdings more than likely were not all purchased at the same time; thus, they have different origination dates. If the holdings are held for less than 12 months and then sold, this will produce a short-term capital gain. Short-term capital gains are taxed as ordinary income rates which are typically higher than the capital gains rate. If the holdings are held for longer than 12 months, then it is a long-term capital gain and thus typically taxed at a lower rate. This could have a considerable impact on the taxes that you owe. Also, not all the holdings are equal as to the interest and dividends they produce. Some of the holdings may have higher dividends and interest than others (Journal of Accountancy: Tax Considerations When Dividing Property in Divorce).

My point is, don’t think because you are splitting something evenly that the future tax implications are even too. They may not be. Therefore, do some digging, or better yet, hire an experienced financial planner with a CPA background to help you out. I just may know someone that fits that description…it’s me again!

Pursuing Your Best Self

In my book, Unforeseen Exit: When You Find Yourself Facing Divorce & Suddenly Single, I tell my story of navigating an unforeseen divorce. By openly telling my story, I want to provide guidance and support to those who have found themselves in similar circumstances, so they can pursue their best self personally and financially!

For more information on how I can support you as your financial planner, schedule a discovery meeting with me today!