Divorce and Taxes
Upon the dissolution of a marriage, all marital property will have to be divided amongst the spouses. The dividing of most assets will not trigger a tax event. The IRS has created a rule allowing for any spouse-to-spouse transfer that takes place incident to divorce to be tax-free. Thus, a lump sum payout from a checking or savings account can be transferred with no tax implications. Vehicles, jewelry, and other personal property can also be transferred tax-free.
Some marital assets, however, automatically trigger tax consequences that can be costly if not handled property. For instance, retirement accounts are specifically designed so that early withdrawals result in a major tax hit. So regardless of the IRS rule about tax-free transfers incident to divorce, if a divorcing spouse withdraws funds from a retirement account to give to his former spouse, he will inevitably face tax consequences.
Retirement accounts need to be handled delicately. In order to avoid tax penalties when transferring an IRA, the spouses must follow the procedure to transfer or rollover the funds to another retirement plan in order to avoid a tax issue. Other retirement accounts are more complicated and require additional steps in order to be tax-free. For qualified employer accounts such as a 401K or a pension, the spouses must obtain a Qualified Domestic Relations Order to ensure the transfer is tax-free.
The transfer of stock options can also be tricky; the IRS treats statutory stock options different from non-statutory stock options. The latter option will result in a capital gain when exercised, while the former will not. Sometimes parties will simply agree to a monetary value that the options will be worth once exercisable, and the non-owning spouse will receive that amount as a lump sum from the other spouse. Another option is to include a provision in the separation agreement or court order expressing that the employee-spouse who owns the options will hold them on behalf of the other spouse until they are exercisable.
Selling the marital residence incident to divorce can also create tax issues. Depending on the circumstances, the parties may be hit with capital gains taxes.
The bottom line is that spouses should be aware that splitting assets can be complicated and costly if not done correctly. In order to make sure neither spouse takes a tax hit, both spouses should consider the tax consequences of any transfer and consult a professional if there are any concerns.