Divorce is essentially a financial transaction. You and your spouse (through settlement or alternative dispute resolution or the court) must divide all of your marital assets and debts so that each of you walks away with your own separate property. An important fact to keep in mind is that the transfer of assets between spouses is not taxable, so you won’t be paying taxes on assets you receive in the divorce simply because they are transferred to your name alone. However, it is important to know that taxes can influence the actual value of assets, which should influence how they are divided.
Pre-Tax vs. After-Tax Assets
On their face, a bank account with $100,000 and a traditional IRA with $100,000 look as if they have the same value. However, the bank account funds are after-tax. You’ve already paid tax on the income those funds came from. If you withdraw the money, you don’t have to pay tax on it. The traditional IRA funds, on the other hand, are pre-tax dollars. You didn’t pay tax on income that you placed into a traditional IRA. That money has not yet been taxed and when you remove it, it will be taxed. Therefore, it is actually worth less than the bank account funds. Not to mention that those funds cannot be withdrawn until retirement age without paying a 10% penalty.
The tax status of assets should always be kept in mind when considering settlements or explaining your position to the court. If your spouse keeps the bank account and you keep the IRA, you are not receiving assets that are equal in value even though they appear to be on their faces.
The pre-tax and after-tax value of assets must also be considered when sold to pay off marital debt. If a pre-tax asset is sold, taxes must be paid on the sale, and early withdrawal penalties may be due on IRA distributions. Selling the asset and paying the debt involves incurring additional costs.
Tax Cost-Basis
Another important tax concept that must be considered is the cost basis of an asset. The cost basis generally is what you paid for the asset. When taxable gains are calculated, the cost basis is subtracted from the current value of an asset. If you have an investment account with a value of $50,000 and a basis of $25,000, then $25,000 of that account is taxable. But if there is a $50,000 account with a cost basis of $40,000, only $10,000 is taxable. The lower the cost basis, the more that is taxable when the asset is sold, and the less valuable the asset.
Evaluating the cost basis is a key step in determining value and is one many people overlook. Two accounts might seem to be of identical value at first glance, but an analysis of value shows that the one with the higher basis is actually of higher value since less of it will be taxed when sold.
Another important note about cost basis is that when you receive an asset through divorce, the asset’s original basis carries over to you. The basis does not change to the value you receive at the time of the transfer. The basis remains and is not carried forward.
QDROs
When an employer-sponsored retirement asset is divided in divorce, a special document called a Qualified Domestic Relations Order (QDRO) must be created. This is an order that directs the administrator of the plan to transfer some or all of the asset to the non-employee spouse (the one who is not named on the retirement asset). So, for example, if Spouse 1 has a retirement plan and the court orders that half of that must be transferred to Spouse 2, a QDRO must be created to direct the administrator to transfer the asset. This is important when it comes to taxes because when a retirement asset is transferred via a QDRO, there is no early withdrawal penalty, and there are no taxes due on the funds transferred to Spouse 2.
The Need for Professionals
All of these scenarios show that an asset may not truly be worth what it appears to be at face value in a divorce settlement. Because of this, it is essential that you work with an experienced divorce attorney who can analyze all of the assets involved in the case and advise you about tax implications.
If necessary, your attorney can consult with financial experts and evaluators in valuation, taxes, and retirement planning who can provide detailed and careful analyses of all relevant assets to maximize your divorce outcome. The more complex your case is, the more significant the tax implications. A well-thought-out financial distribution plan can maximize your takeaway from the divorce.
The attorneys at Burnham Law review all of your assets and debts and help you consider all the tax implications involved to optimize your asset package. Contact us now at 303-647-9767 to schedule an appointment about your divorce.