Tax Guy: Did quarantining hasten the end of your marriage? If so, avoid these tax pitfalls

Tax Guy: Did quarantining hasten the end of your marriage? If so, avoid these tax pitfalls

10 Jun    Finance News

Good grief. As if the COVID-19 crisis has not already done enough damage, all the extra stress and forced togetherness may be causing some married couples to call it quits. If you’re going down that road, anecdotal evidence suggests you’ll have plenty of company. Sad, but apparently true.

On top of all the other stuff, getting divorced can be a major financial transaction. As such, it can have major tax consequences. And there are tax pitfalls to avoid — if you know about them. Don’t expect your lawyer to understand all the tax implications of your impending marital split. Some otherwise-competent divorce attorneys are not fully up to speed on divorce-related tax issues.

In this column, we address one very important divorce-related tax issue: how to divide up IRA and qualified retirement plan balances between you and your soon-to-be ex without triggering unexpected and unfair tax outcomes. Bottom line: you need to plan ahead to make sure the federal income tax results turn out OK for you. If you don’t plan ahead, the tax results can be dire. Here’s what you need to know to avoid that fate.

Divide up IRA balances the tax-smart way

Our beloved Internal Revenue Code allows divorcing couples to divide up IRA balances without adverse federal income tax consequences. Say you’ll be transferring IRA money to your soon-to-be-ex as part of the divorce settlement. You should arrange for a tax-free transfer of money from your IRA into an IRA set up in your ex’s name. Do this via a direct transfer (AKA trustee-to-trustee transfer) from your IRA into your ex’s receiving IRA. That way, the transferred funds never pass through your hands, which is what makes it a tax-free deal for you.

After the transfer, your ex can manage the receiving IRA and defer taxes until he or she begins taking money out of the account.

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This drill applies equally to traditional IRAs, SEP accounts, and SIMPLE IRAs. They are all considered traditional IRAs for this purpose.

So far, so good. But you must be very careful here. The aforementioned tax-free transfer drill is only allowed when your divorce agreement requires the transfer.

What happens if money from your IRA gets into your ex’s hands — before or after the divorce — without such a requirement? You’ll be treated as if you received the IRA money in a taxable distribution and then gave the money to your ex. That means you’ll be on the hook for the income tax bill from the deemed taxable distribution — even though your ex wound up with all the money. To add insult to injury, you’ll usually owe the dreaded 10% early withdrawal penalty tax if this happens before you’ve reached age 59½. Your ex won’t have any complaints, because the money from your IRA is received without any tax consequences for your ex. All the tax consequences are on your side of the deal, and they are all bad news for you.

To avoid this unexpected and unfair tax fate, never transfer IRA money to your ex in advance of a legal requirement in your divorce agreement to do so.

Divide up qualified retirement plan money the tax-smart way

Say you participate in a qualified retirement plan at work — such as a 401(k) plan or profit-sharing plan. Or you are self-employed and have a small business qualified plan, such as a Keogh plan or solo 401(k) plan.

To divide up qualified retirement plan accounts the tax-smart way in a divorce, you need to establish a qualified domestic relations order, or QDRO. A QDRO is boilerplate language that should be included in your divorce papers. First and foremost, the QDRO establishes your soon-to-be-ex’s legal right to receive a designated percentage of your qualified retirement plan account balance or designated benefit payments from your plan. The good news for you is that the QDRO also ensures that your ex, and not you, will be responsible for the related income taxes when he or she receives payouts from the plan.

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The QDRO arrangement also permits your ex-spouse to withdraw his or her share of the retirement plan money and roll it over tax-free into an IRA (assuming the plan permits such a withdrawal). That way, your ex can take over management of the money while postponing income taxes until distributions are taken from the rollover IRA.

Bottom line: with a QDRO in place, both you and your ex are treated fairly tax-wise, because the person who gets retirement plan payouts owes the related income taxes. Who can argue with that?

Here’s the rub. If money from your qualified retirement plan account gets into your ex’s hands without a QDRO in place, you face a dire tax outcome. You’ll be treated as if you received a taxable payout from the plan and then turned the money over to your ex. So, you’ll owe the tax bill while your ex gets the money tax-free. To boot, you’ll usually owe the dreaded 10% early withdrawal penalty tax if this happens before you’ve reached age 59½. To sum up: in the absence of a QDRO, all the tax consequences are on your side of the deal, and they are all bad news for you. So please make sure that your divorce agreement includes the tax-saving QDRO language.

The no-more-deductible-alimony factor

Before the Tax Cuts and Jobs Act (TCJA), you could deduct properly structured alimony payments made to your ex, and your ex had to include the payments in his or her taxable income. But the TCJA permanently eliminated deductions for alimony payments required by post-2018 divorce agreements. These payments may also be called spousal support or spousal maintenance. Whatever they are called, you can’t deduct them anymore under the federal income tax rules, and your ex receives these payments federal-income-tax-free.

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The message: when structuring your divorce settlement, consider giving your soon-to-be-ex a share (or a bigger share) of your IRA and/or retirement plan money in lieu of making now-nondeductible alimony, spousal support, or spousal maintenance payments. If you follow the advice given here, your ex will owe the taxes on the IRA or retirement plan money that he or she receives under the divorce agreement. Tax-wise, that may be a better deal for you than making a bunch of non-deductible payments and still being on the hook for taxes on your IRA and retirement plan money when you eventually take distributions.

The last word

In divorce, you can divide up IRA and qualified retirement plan money the tax-smart way or the tax-dumb way. Please go with the first option. As stated earlier, some otherwise-competent divorce attorneys are not so great on the tax stuff, but they might not admit it. You need a tax pro who has done lots of divorce-related work on your side. While your divorce attorney might be able to fill that role, don’t take it for granted.

Finally, don’t let all the COVID-19 stress cause you to drop the ball on important divorce-related considerations, whether they have to do with taxes or other matters. Stay focused, keep your eye on the ball, and be careful out there.

Note: For some good general advice for divorcing couples in the COVID-19 era, see this previous MarketWatch story.

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