When you are going through the divorce process, particularly the property division process, you may end up focusing on what you are getting and the monetary value of what you are getting. This will do your finances a serious disservice. Considering the tax consequences of what you are awarded during property division could save you a significant amount of money.
Section 1041 of the Internal Revenue Code makes the division of property incident to divorce a non-taxable event, meaning it will not end up as a recognize loss or gain for tax purposes. A property transfer is considered incidental to divorce if the transfer of property was pursuant to a divorce decree and did not occur more than six years after the date the marriage ended. Now, you may be wondering why you would need to worry about tax consequences of divorce if the Internal Revenue Code makes it a non-taxable event. One reason is the hidden costs of tax basis.
Tax basis is the price used in calculating capital gains tax when property is sold. Many forms of investments are subject to capital gains tax when they are sold. Consider this in dividing your marital property. An investment such as the marital home which may be valued at $250,000 is not equal to $250,000 in stock options. The stock options will be subject to capital gains tax when sold. This is an important consequence to consider in negotiating division of the marital estate.
Additionally, there is the division of retirement assets to consider. Retirement accounts can be major assets to be divided during divorce. Divorcing employee spouses can permit funds to be withdrawn and allocated to non-employee spouses without penalty while other pre-retirement withdrawals of funds from a retirement account can result in large tax penalties. However, you absolutely must comply with the correct procedures to make sure the retirement account transactions incident to divorce are not taxed.
Pursuant to the Employee Retirement Income Security Act (ERISA), retirement fund withdrawals will usually avoid tax penalties if it is specified in a qualified domestic relations order (QDRO). Any QDRO must comply with ERISA and thus requires careful drafting. It is also important to note that some types of retirement plans will require a different type of property division device other than a QDRO. The tax consequences for failing to comply with the necessary procedures can be severe. You may want to consider contacting the requirement plan administrator to check and see what type of property division device is required to avoid tax liability. Once this is confirmed, consider sending a draft of the QDRO or other device to the plan administrator to make sure everything is in order. It is up to the plan administrator. Even if you have a court-signed QDRO, the plan administrator may not honor it if it fails to comply with all requirements.
Doing things like considering tax consequences during the divorce process may seem like just adding more and more to your to-do list. Just remember that what you do to protect yourself during divorce can have lasting benefits for your financial situation.