When couples get divorced, they need to divide their assets and debts in a process called equitable distribution. It’s not always a straight 50/50 split, but rather what’s most fair based on the couple’s situation. How you divide your assets affects more than your divorce, however. It can also affect your tax bill.
If you’re ending things with your spouse, it’s important to ask about the tax considerations and do what you can to avoid paying too much to Uncle Sam. However, tax laws, both federal and state, are complicated and frequently changing. This can make it hard to figure out exactly how these laws apply to your divorce situation.
At Untying the Knot, we know that every divorce is different, and our goal is to help you make informed, tax-efficient decisions about your assets. In this blog, we’ll explore tax considerations for equitable distribution and the benefits of having a smart strategy.
Understanding Equitable Distribution
The process of dividing assets and liabilities isn’t a one-size-fits-all. Courts look at what each spouse brought to the marriage, what was earned or accumulated during the marriage, and what is needed for a stable future post-divorce for both spouses.
First, there’s a need to determine what’s considered marital property and what’s separate. Marital property includes most assets and debts gathered during the marriage, while separate property is what each person had before the marriage or received individually as a gift or inheritance.
The actual division involves several steps:
- Identifying: Listing out all assets and liabilities.
- Categorizing: Deciding what’s marital property and what’s non-marital property.
- Valuing: Determining the worth of all marital property.
- Dividing: Deciding who gets what based on fairness, not necessarily equality.
Sometimes, one person might get more of the assets if, for instance, they earn less or have custody of the children. Other times, debts and assets might be split based on who benefited more from them during the marriage.
Tax Implications of Asset Division
Here’s what you need to know about the tax considerations in equitable distribution.
Capital Gains Tax on Appreciated Assets
If you’re splitting up assets worth more now than when you bought them, keep in mind that selling these items could mean paying capital gains tax. This tax is on the profit you make from selling something that has increased in value.
Tax Consequences of Selling or Transferring Property
There are different tax impacts when a property changes hands during a divorce. For instance, if you transfer a property to your ex-spouse, you won’t pay taxes immediately. However, if they sell it later, the taxes will be based on how much the property was originally bought for. Also, the timing of when you sell or transfer property can change the tax consequences.
Treatment of Retirement Accounts and Pension Plans
While retirement accounts and pension plans are substantial assets in a divorce, dividing them can be tricky due to tax rules. You might need a legal document called a Qualified Domestic Relations Order (QDRO) to split these accounts without incurring immediate taxes.
Identifying Tax-Advantaged Assets
In a divorce without court, some assets are treated more favorably by tax laws, meaning they can lead to lower taxes now or in the future. A few examples include:
- Primary Residence: When you sell your main home, you might not have to pay taxes on much of the profit due to the capital gains tax exclusion.
- Retirement Accounts: With 401(k)s and IRAs, your money grows without you having to pay taxes on the gains right away. Taxes are only paid when you take the money out.
- Health Savings Accounts (HSAs): HSAs are a triple tax win. Your contributions are tax-deductible, the money grows tax-free, and you can withdraw it without paying taxes if it’s for qualified medical expenses.
To make the most of these tax-advantaged assets, you must:
- Understand Specific Tax Benefits: Each asset has its own set of rules. Understanding these rules can help you make more informed decisions.
- Think About Now and Later: Look at how taxes might affect you today and in the future. For example, if you’ll be earning more down the line, keeping assets that grow tax-free until you use them (like IRAs) can be a smart move.
- Match Assets with Your Needs: Seek assets that fit your financial goals. If you need money soon, go for ones that give immediate tax benefits. Likewise, if you’re planning for the long term, pick assets that save on taxes over time.
Valuation of Assets for Tax Purposes
Getting the value of your assets right is key to a fair divorce settlement. You must figure out how much each asset is worth. If the values are off, you might end up paying more or less in taxes than required.
Different assets need different valuation methods:
- For Real Estate: Get a professional appraisal. A professional will look at your property and compare it to similar ones to set a price.
- For Personal Items (like art or jewelry): A professional appraiser can give you a value based on the item’s condition, rarity, and market demand.
- For Investments and Savings Accounts: You can check the latest statements for the current value.
Alimony and Tax Considerations
The Tax Cuts and Jobs Act of 2017 (TCJA) brought significant changes to how alimony is treated for tax purposes.
- For the Payer: If your divorce happened after January 1, 2019, you can’t deduct alimony payments from your taxes anymore.
- For the Recipient: If you started getting alimony after January 1, 2019, you don’t have to count it as taxable income on your tax return.
Since alimony is no longer tax-deductible, here are some strategies to help lower the tax impact of these payments.
- Consider Lump-Sum Payments: You could choose to make a single, big payment for alimony instead of paying little by little over time.
- Be Open to Different Payment Plans: Think about mixing alimony with other ways of splitting your things. For example, you can offer to give up certain assets instead of paying alimony.
- Get Professional Help: It’s a good idea to talk to a lawyer or a financial advisor. They can help you figure out the best and most tax-friendly way to handle alimony.
Child Support and Tax Implications
Child support, like alimony, is non-taxable. This means you cannot deduct it from your income. Usually, the parent who has custody of the children for most of the year gets to claim them as dependents on their tax return. This can lead to tax benefits, like credits for childcare expenses.
But sometimes, parents might agree to let the non-custodial parent claim the kids. It’s important to decide this and include it in your divorce agreement.
Qualified Domestic Relations Orders (QDRO)
A Qualified Domestic Relations Order, or QDRO, is a legal order that lets you split up and distribute retirement accounts, like 401(k)s or pensions, between you and your ex-spouse without triggering immediate taxes or penalties.
A QDRO tells the company managing the retirement account how to split it between the divorcing couple. But remember, if you split the retirement account, both you and your spouse will have to pay taxes on the money when you use it, depending on the account type.
Tax Planning Strategies for Equitable Distribution
When you’re dividing assets in a divorce, it’s smart to have a plan for handling taxes. Here’s how to do it.
- Work with a Tax Professional or Financial Advisor: A tax professional or financial advisor can help. They know all about tax considerations and can guide you in making the best decisions for your tax situation.
- Time Your Asset Transfers and Sales Wisely: Pick the right time to sell/transfer assets like property or stocks to reduce your tax bill.
- Think About Taxes When Making Your Settlement Agreement: As you agree on who gets what, always keep taxes in mind. Some things might seem to have some specific value now, but after taxes, they can be very different.
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By thinking about taxes in advance, you can better manage your money during and after the divorce. The aim is to get a fair deal and understand how these choices affect your finances in the long run.
Ready to navigate the financial complexities of your divorce with confidence? Visit Untying the Knot for guidance and resources tailored to your unique situation. Contact us today.