What You Need to Know About Taxes in a Gray Divorce

Wedding rings sit atop a stack of cash.

Editor’s note: This is part nine of an ongoing series throughout this year focused on helping older adults navigate the financial difficulties of gray divorce. See below for links to the other articles in the series.

Divorce may be less of a certainty than death or taxes. But the latter can take a big bite out of a divorce settlement.

Those of you getting divorced later in life, also known as a gray divorce, will have less time to recover from the financial hit of divorce and will want to make sure that Uncle Sam takes no more than you are legally required to pay.

Divorce settlements are generally not taxable events, meaning that the division of marital property doesn’t trigger immediate tax liabilities. IRS Revenue Code 1041(a) states that no gain or loss shall be recognized on the transfer of property from an individual to a spouse or a former spouse if that transfer is incident to divorce.

But transferring property is different than selling property. And sometimes spouses will need to sell assets after divorce to raise cash. You need to be aware of the tax effect on the sale of that property now or in the future. You may end up with less money from your divorce settlement than you planned.

Property division and cost basis

When dividing marital property, it’s key to understand the cost basis of each asset.

The cost basis of an asset is, essentially, the original purchase price. With real estate, the cost basis can also include improvements. If you sell an asset with a low basis, you may face significant capital gains taxes on those unrealized gains. For instance, if one spouse keeps an investment account with a low basis while the other takes an account with a higher basis (or even unrealized losses), the spouse with the lower-cost-basis assets may end up paying more in capital gains tax later on.

Another thing: Many attorneys fail to examine their client's tax returns to see if tax-loss carry-forwards (TLCs) are present. These TLCs have value. They can be used to offset capital gains in the future and should be considered on the marital balance sheet.

Capital gains taxes and the primary residence exclusion

If the marital home is sold as part of the divorce, both spouses may be eligible for the primary residence exclusion of up to $250,000 in capital gains ($500,000 if filing jointly) if they meet the ownership and use requirements. Timing the sale before the divorce is finalized or both spouses move out can maximize this exclusion.

A Certified Divorce Financial Analyst (CDFA®) can work with your tax professional to help you review strategies to qualify for the maximum exclusion. (Note that investment properties don't qualify for the primary residence exclusion.)

Tax-efficient asset division

Brokerage accounts may carry unrealized capital gains, meaning future taxes will be owed upon sale.

Retirement accounts like traditional IRAs and 401(k)s, which provide a tax deduction on the contribution, are subject to income taxes upon withdrawal, so their value may be less than their current balance, compared to an after-tax account.

Consulting a tax pro or CDFA® to calculate the tax-adjusted value of assets can help ensure a fair division.

Avoiding early-withdrawal penalties

Retirement accounts are often one of the largest marital assets. But watch out: Dividing them incorrectly can trigger taxes and penalties.

A qualified domestic relations order (QDRO) is a court order required to divide certain retirement accounts, such as 401(k)s and pensions, without incurring taxes or early-withdrawal penalties. The receiving spouse (referred to as the alternate payee) can roll over their share into their own retirement account, such as an IRA, ensuring the funds remain tax-deferred.

But if you need this money for immediate expenses and are under age 59½, be careful. Rolling those retirement funds into an IRA and then taking a distribution will subject you to a 10% early-withdrawal penalty. However, the IRS allows you to receive this money without a 10% penalty if you take it directly from the 401(k) you've been awarded pursuant to the QDRO before rolling it to an IRA. Of course, you still need to pay income taxes on the distribution.

Tax filing status

Your tax filing status for the year is determined by your marital status on December 31. If your divorce is finalized before that date, you cannot file jointly, even if you were married most of the year.

Carefully planning the timing of the divorce can help you take advantage of the most beneficial filing status. Sometimes the difference is enough to change the anticipated date of divorce from the end of a calendar year to the following January. Of course, filing jointly means sharing liability for any taxes owed. If your soon-to-be ex has complicated financials or dubious deductions, it may be safer to file separately. You should always consult with a tax professional to determine which option makes the most sense for you.

The divorce team

Navigating the murky tax waters of divorce requires the expertise of tax professionals, divorce financial planners and divorce attorneys, all working together. These professionals can:

• Review the tax implications of various asset divisions
• Structure settlements to maximize tax benefits for both parties
• Help you to prepare for post-divorce tax obligations and opportunities

While hiring advisers adds to the upfront cost, it is likely you will need their help anyway, and their guidance can save significant amounts in taxes and financial stress in the long run.