Taxation may not be your first thought when initiating a divorce negotiation, but it is important to consider them to avoid costly mistakes. While we always recommend you work through your tax questions with your accountant/CPA, I put together a list of the most common tax issues when going through a divorce as a starting point.
1. Taxation of Different Account Types
Non-retirement, traditional retirement, and Roth retirement accounts are all taxed differently. I have provided a simplified example below to demonstrate the differences. In this example, we will assume the account owners are over age 59 ½. Traditional retirement account distributions are taxed at an ordinary income tax rate. Roth IRA withdrawals are not taxed, assuming the account has been held for at least five years. And finally, non-retirement accounts are taxed on their gains and income. In most cases, the capital gains tax on these accounts falls in the 15% range, often lower than the ordinary tax assumed on traditional retirement withdrawals. The differences should be reviewed during your negotiations, as you can see the net amount received in this scenario is quite different for each account, despite the gross withdrawal of $50,000.
2. Employer-sponsored plans vs. IRAs
If you are splitting a retirement account, you should be aware that different types require different documentation. Splitting an employer-sponsored plan will likely require a Qualified Domestic Relations Order, something your attorney can assist you in providing. Individual Retirement Accounts (IRAs), in most cases, require a form or letter along with a copy of the divorce decree. Pulling money from these accounts without the proper documentation and guidance may trigger a taxable event and penalty.
3. Accessing retirement funds without penalty
Given that a divorce is such a significant life change, cash may be needed to fund for new expenses, such as a down payment on a home or the purchase of a new car. Many couples have most of their assets held in employer-sponsored retirement accounts that will penalize distributions taken prior to age 59 ½. The good news is that with proper documentation, a one-time lump sum distribution from employer-sponsored retirement accounts is permitted without incurring a penalty, though taxes may still be owed.
4. Alimony/child support
One last item worth mentioning is the taxation on alimony or child support received. For agreements made prior to December 31, 2018, alimony was taxed to the receiver. Alimony agreements that began on or after January 1, 2019 are now taxed to the spouse that pays alimony, instead. The new rules for alimony now match how child support payments are taxed.
When working through your settlement options, it is important to be aware of the potential tax implications of your decisions. As always, we recommend you continue to work closely with your attorney, CPA, and financial advisor to help you in making decisions that are best for your unique situation.