As you go through your divorce, you will likely have to make many decisions regarding taxes. It may not even be apparent that taxes are a factor or something to be considered when you are thinking through your options. But, there are reasons there is an entire tax profession and over 60,000 pages of tax code – taxes are expensive and confusing!
It is unequivocally important to understand the basics so that you can make informed decisions and optimize your settlement.
That being said, do not feel like you are on an island. There are many professionals who can guide you every step of the way. Similar to having an attorney to help you through your divorce, financial planners and accountants should be part of your empowerment team to ensure you maximize your post-divorce assets and cash flow on an after-tax basis.
Here are a few of the most common initial questions, consider this Divorce Taxes 101.
Are taxes owed on a divorce settlement?
Transferring assets between spouses because of a divorce does not generally result in a tax consequence.
Should I file jointly or separately?
Your marital status on December 31st determines your filing status that year. Couples sometimes wait until January to finalize the divorce to reduce taxes owed for the preceding year. This works whether you’re filing jointly or married filing separately for that year.
What is Head of Household filing status?
To claim head of household status, you must be legally single, pay more than half of the household expenses, and have either a qualified dependent living with you for at least half the year or a parent for whom you pay more than half their living expenses.
What are the tax differences to consider when dividing qualified/retirement 401(k) and IRA accounts versus non-qualified/after-tax joint or individual assets?
Ordinary income rates apply when funds are withdrawn from a qualified/retirement plan. Keep in mind there is likely an additional 10% penalty if funds are withdrawn when the individual is under age 59.5.
Capital gains rates apply on withdrawals from non-qualified/after-tax accounts, which are typically less than ordinary income rates. Also, in selling positions to raise funds, one is taxed only on the gains booked, not the full withdrawal, as is the case for distributions from a qualified account.
It’s critical to understand that dividends and interest earned in an investment account, as well as capital gains distributions, are taxable in the year received. They are not taxed until withdrawn from tax-deferred accounts.
When deciding on the split of an investment account, pay attention to the cost basis (purchase price) of the securities.
Pro tip: Be sure the settlement agreement addresses who is to receive any tax refunds, loss carryforwards, or tax debt.
Bonus Pro Tip: In the last year of filing a joint return work with a CPA to determine how much each spouse owes based on their respective income. Splitting the taxes owed in half may not be reasonable. Situations where this might apply are a dual income family or when spouses have been living separately and supporting only themselves. It’s important for the CPA to be thoughtful on the division of tax refunds, penalties, deductions, and the claiming of dependents.
Types of Accounts
Not all types of accounts are equal when dividing assets among spouses. Remember when I mentioned that taxes have a role, even when it is not apparent?
Here’s an example. Let’s say you and your spouse have $1 million of net worth, $500,000 in a traditional IRA and $500,000 in a taxable account. Simply giving one spouse the retirement assets and the other the taxable assets would not be considered an equitable division because of the difference in tax treatment at withdrawal. Depending on the income of each spouse, the IRA may have ~$100,000 of embedded taxes and be worth only ~$400,000 after tax, while the taxable account may have only ~$20,000 of taxes owed and be worth ~$480,000 after-tax.
The takeaway is that it is usually more desirable to receive taxable assets in a divorce settlement versus a traditional IRA. Roth assets are the most advantageous to receive because of the tax-free treatment of withdrawals.
Taxable accounts (also known as brokerage accounts, after-tax or nonqualified accounts) are funded with dollars that have already been subject to income tax. Growth on these dollars is taxed at preferential capital gains rates of 0%, 15%, or 20%, depending on your situation.
Tax-Deferred accounts include traditional IRAs, qualified retirement accounts, pensions, 401ks, 403bs, Deferred Compensation plans, SEPs, Keoghs, and Simple plans. These accounts receive a tax deduction when money is contributed and are taxed as ordinary income rates of 10%, 12%, 22%, 24%, 32%, 35%, or 37% when money is withdrawn. These accounts are typically subject to an additional 10% tax penalty if withdrawn before age 59 ½, though there are exceptions to this.
Roth IRAs or Roth 401ks do not receive a tax deduction when money is contributed but are not taxed when money is withdrawn (assuming the withdrawal occurs after 5 years, and the account owner is over age 59 ½). These are the “best” accounts to receive from a tax perspective as all the tax was paid upfront and any growth or future withdrawals are free from Uncle Sam’s grasps.
Tax Considerations Specific to Divorce
If you’re a bit overwhelmed reading about taxes, take a deep breath and have confidence you will make smart decisions with the help of your empowerment team. Below are the essential concepts to understand about taxes and divorce. You likely know many of the following concepts.
Married Filing Joint, Married Filing Separate, Single, or Head of Household are all examples of filing status. Spouses ﬁle based on marital status as of December 31 and are both liable for everything reported or not reported on a joint return regardless of who earned the income.
A Qualified Domestic Relations Order (QDRO) is a legal document that directs the administrator of a qualified retirement plan to distribute a portion of retirement benefits to the spouse so that the transfer is not taxable. QDROs are exempt from 10% penalty on withdrawals before 59 ½. IRAs do not require a QDRO and are not exempt from the 10% penalty on early withdrawals.
Tax arbitrage is smart tax planning which maximizes the after-tax value of family assets by taking advantage of one spouse having a lower tax rate than the other spouse.
Custodial parent The IRS defines the custodial parent as the parent that has the child for more overnights. If the overnights are equal, the parent with the higher income is the custodial parent.
Form 8332 is the IRS form that releases claim to exemption for a child by the custodial parent so that the noncustodial parent can claim an exemption for the child. Although personal exemptions were eliminated in the 2017 Tax Cuts & Jobs Act, there is still benefit to claiming minor children for the child tax credit.
Basic Tax Terms and Concepts
In a large sea of tax jargon, it is helpful to have a basic understanding of some of the terms you will likely hear. This is the vocabulary you should familiarize yourself with as you discuss taxes in your divorce.
- Marginal tax Rate: This is the tax rate you would pay on one more dollar of taxable income. Typically, this is your highest tax bracket.
- Ordinary Income: Income that comes from the following sources: W-2 earnings, interest, pension income, IRA/401k withdrawals. These are taxed at the higher rates 10%, 12%, 22%, 24%, 32%, 35% or 37%.
- Long-Term Capital Gains: The tax that applies to an increase on investments held more than 12 months. In 2022, the long-term capital gains tax rates are 0%,15%, or 20%. These are typically lower than your earned income rates.
- Short-Term Capital Gains: This is tax that applies to an increase on investments held less than 12 months and are taxed at ordinary income rates.
- Capital Losses: The loss incurred when an investment has decreased in value from it’s original purchase price. Capital losses can be long term or short term depending on whether it was held for more or less than 12 months.
- Capital Losses offset Capital Gains: Means that you can use any losses that you have on an investment to offset any gains. If you don’t use all of the losses in a given year, you can carry forward these losses and use them in future tax years – this is a valuable asset to negotiate for, if available.
- Earned Income: W-2 earnings and 1099 self-employment income are subject to social security tax. Earned income is required to make IRA/401k/403b/Roth IRA/Roth 401k contributions.
- Standard Tax Deduction: A preset amount (based on filing status) and is the portion of income not subject to tax that can be used to reduce your tax bill. Taxpayers can either use the standard deduction or itemize their deductions.
- Itemized Tax Deduction: Varies by taxpayer and includes mortgage interest, medical expenses, and charitable donations. The amount for property taxes and state income taxes combined is limited to $10,000 per year.
- Mortgage Interest Deduction: Deduction on mortgage interest on the first $750,000 of a mortgage used to acquire or improve a new home. Interest on home equity loans not used to acquire or build a home is no longer deductible.
- Estimated Tax Payments: The IRS requires quarterly payments of taxes on earned income that doesn’t have taxes withheld or on investment income.
As taxes can get complicated during a divorce, it’s most important to seek the help of professionals familiar with both the legal aspects of divorce as well as tax nuances. Email our firm’s divorce practice group at [email protected] for further information and for a copy of our 2022 tax chart.
What is taxing you in your divorce?