This article is a continuation from Part 1 featured in our January magazine. If you are going through or preparing to go through a separation, I don’t have to tell you it can be a traumatic time. And when you are forced to make some big decisions in the midst of that turmoil, it can cloud your thinking. To make matters worse, the financial details around divorce is foreign to most of us – the combination of these two factors can make decision making during this time perilous.
After many years of helping people through these times, I am sharing a top ten list. In this article, lets look at 4-6.
Mistake #4: Not Understanding the Rules of Retirement Accounts
Normally, distributions from a retirement plan prior to age 59 ½ are considered “early distributions” and are subject to a 10% penalty tax as well as ordinary income tax. An exception to this rule, however, is a transfer to an ex-spouse as part of a divorce settlement. A Qualified Domestic Relations Order (QDRO) is typically used to affect this transfer. Income taxes still apply, so any assets you receive from a “qualified plan”, such as a 401(k), will be subject to a mandatory 20% tax withholding. For example, if you are awarded a $100,000 distribution from an ex-spouse’s 401(k) you will actually receive only $80,000 due to the withholding.
To avoid this mandatory withholding, the transfer must be made directly to another retirement account, such as your own IRA. Once the assets are in your retirement account, you are now subject to the early distribution rules. If you need some of the assets to live on, or pay bills, make sure you take them out prior to transferring them to an IRA to avoid the 10% penalty.
It is important to note that IRA’s are not qualified plans, so a QDRO is not needed to divide the assets. The downside is that you are not allowed to take a direct distribution; you must deposit any distribution from an IRA directly to your own IRA. If a check is sent to you, you must deposit the money into your own IRA within 60 days to avoid a taxable distribution. It’s always best to transfer funds directly between accounts to avoid the 60-day requirement.
Mistake #5: Overlooking Debt and Credit Reporting Issues
Nothing is worse than starting out a new life with bad credit. Several steps can be taken during the divorce process to minimize the chances of this occurring.
First, obtain a copy of your credit report from all three reporting agencies: Equifax, TransUnion and Experian. This will identify all joint accounts, accounts you may not have been aware of, and any potential credit problems. You are allowed one free credit report per year, and can obtain it by going to www.annualcreditreport.com.
Be careful about closing down joint accounts. If possible, it’s better to have one of the account holders removed to preserve the credit history of that account. If you don’t have your own credit card and lack a good credit history, you should apply for a card while you are still married. If you wait until after the divorce, you will probably find it quite challenging to obtain credit – especially in these economic times.
Regarding income tax debt, even if the divorce is final, you may not be exempt from future tax liability. For three years after the divorce, the IRS can perform a random audit of a divorced couple’s joint tax return. If it has good cause, the IRS can question a joint return for seven years.
To avoid any potential problems down the road, your divorce agreement should have provisions that spell out what happens if any additional penalties, interest or taxes are found as well as where the funds come from to pay for any expenses associated with an audit. There is also innocent spouse relief if your ex has created a tax problem and you can show that you had no involvement. This relief is not granted easily, so if there are potential tax problems please consult with a professional.
Mistake #4: Failure to Consider the Impact of Taxes
Capital Gain Tax
It’s imperative that you understand the potential tax liability of your assets. As an example, you may be offered an investment account worth $150,000, but the cost basis is only $50,000. That means there is a capital gain of $100,000 that you must pay at minimum long-term capital gains tax (currently up to 23.8%). This simple oversight could result in a $23,800 tax bill should you liquidate the asset!
In the case of your personal residence, you and your spouse are each allowed a $250,000 capital gain exclusion if you’ve lived in your home for at least 2 of the past 5 years. The mistake I see is where the home is “quit claimed” from one spouse to the other per the divorce agreement, then sold later with a large capital gain. Now there is only a $250,000 exclusion against the gain where there could have been $500,000 had they understood the tax rules.
In a divorce, if the home is owned jointly, the IRS allows each spouse to keep his or her $250,000 exclusion even when one moves out. The “use” rule of two out of the last five years is waived under this exception as long as both spouses meet the ownership test. So before there is any change of ownership of the marital home, be sure these issues are addressed.
Income Tax
Income taxes are effected primarily by alimony payments. Alimony is taxable to the receiver and tax deductible by the payor. Essentially income is shifted from one spouse to the other. Mistakes are made when the impact of this additional tax is not fully considered. Does the alimony push the receiver into higher tax brackets where certain benefits are phased out or lost completely? Does it trigger Alternative Minimum Tax? Without a full analysis, significant tax dollars are often thrown away.
Filing Status
An important tax decision to make is when to finalize the divorce. If you are still married on 12/31 of the tax year, you must file as married either jointly or separately. If you were divorced prior to 12/31 you will each file individual returns. The difference in total tax liability could be substantial, however this is an often-overlooked area. Your best course of action is to consult with a tax professional regarding these options so that you can make the best decision for your situation.
Bill Donaldson is an investment advisor representative with Conscious Capital Wealth Management, LLC (CCWM) and has over 17 years of experience as a financial consultant and divorce specialist. Conscious Capital Wealth Management (CCWM) is an advisory firm redefining wealth management by working with the Whole Person by employing a holistic model that aligns one’s unique financial goals with their overall well-being. Investment advisory services offered through Conscious Capital Wealth Management, LLC, a Registered Investment Advisor located at 381 Hubbard St., Glastonbury, CT 06033. Contact us at 860-659-8299 at www.consciouscapitalwm.com.