You have finally made it to the other side. The paperwork has been finalized, and now it is time to get all the assets and accounts divided so you can move on with your new life. But as money starts to get moved from account to account, there is a common concern about whether the receiving spouse will owe any tax on the assets. Although this should have been considered during the property settlement negotiations, sometimes people don’t think about it until it is all over.
Regardless of where you are in the process, it is important to think about how taxes can affect each of you and the ramifications of accepting one asset over another. Let’s discuss some common tax considerations that you should know before accepting a settlement offer.
1. Selling Real Estate
If you are selling the marital home and dividing the proceeds, there is a limit on the amount of proceeds you can receive without owning any capital gains tax. You may qualify to exclude up to $250,000 of gain on the sale of your home if you are filing as single. Any profits above that would be subject to capital gains tax.
However, you must qualify for this exclusion by meeting the ownership and use test; you must have owned and lived in your home as your primary residence for at least 2 of the last 5 years before you sell it. Therefore, if you are selling a vacation or rental property that is not your primary residence, all profits from the sale of the home will be subject to capital gains tax.
2. Dividing Retirement Accounts
As part of your settlement, you may be dividing different types of retirement accounts. If you are receiving a portion of your spouse’s retirement accounts, is there a taxable impact to you? It depends on what type of retirement account the money is coming from and how you elect to receive the money. Remember that there are non-qualified plans, qualified plans, and non-qualified tax-deferred plans. They all have different tax rules.
If you are moving money from one type of qualified plan to another qualified plan (like a 401k to an IRA), then there is no issue. But if you want to take a distribution in cash from a qualified plan, you will owe taxes.
For example, let’s say you are set to receive 50% of your spouse’s 401k from their retirement plan at work. If you are working as well, you may be able to roll that money into your retirement plan with your employer. If not, then you will probably need to open an Individual Retirement Account (IRA) for that money. When moving the money directly from one account to the other, you will not incur any taxable income or penalty.
However, what if you need some cash to pay off your attorney bill or make a down payment on a new home? In that case, if you take a distribution from a pre-tax retirement account, like a 401k or IRA, you will owe income tax. If you are younger than age 59½, then you will also owe a 10% penalty for taking the money out early. You can get around the 10% penalty, but there are very specific rules and timing in order to do this correctly.
Talk to a CDFA®, Financial Advisor, or Tax Professional for help with these details.
3. Investment Accounts
What if you have investment accounts at a bank or with a financial institution? If you are splitting investment accounts, the accounts are typically divided “in kind,” meaning that you would divide each investment in the same way. If the account is to be divided 50/50 and there are 5 different stocks in the account, each stock position would be divided 50/50 instead of one spouse taking all of a specific stock that may be more valuable and leaving the other spouse with the underperforming investments.
When the account is divided, the cost basis of the investment transfers with it. So, if you bought the stock for $10/share and it is now worth $50/share, you would owe capital gains tax on the profits when you sell the stock. If you like the investments in the account and want to keep them, no tax will be owed on the investments when they are moved into an account in your name. But if you choose to sell the shares down the road, you will owe capital gains tax on the profits.
4. Alimony or Spousal Support
If you have friends or family members who divorced a few years ago and are receiving spousal support, they are probably paying income tax on the payments they receive. However, the tax rules changed effective January 1, 2019. Now, the person receiving spousal support will receive it tax-free, and the person paying spousal support will not be able to take a tax deduction for support paid.
When getting divorced, tax considerations are very important, not only when you are negotiating your settlement, but also when you are making decisions in your post-divorce life. If you have questions about your situation, make sure you reach out to a reputable tax professional or financial advisor to discuss the details.