With so many lavish celebrity weddings in the news recently, incurable romantics very often forget (and who would blame them?) that roughly five out of every 10 marriages end in divorce. That's a 50/50 chance of getting it right—good enough odds if you're a betting person. But if a client is not the gambling type, then he or she needs a financial advisor well versed in the division of marital assets, its tax implications and state laws. Such an advisor can help one side of a divorcing couple make the best of a tough and life-changing situation.
The following case is a fictional one that mirrors numerous challenges in divorce as assets are identified as separate or marital, divided and tax consequences are determined. Let's say the client resides in a community property state such as Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin. In these states assets identified as marital are divided in a 50/50 rule of property division, a rule about which the law is very specific. The other states not mentioned operate under an "equitable division" rule in which assets are split according to what the divorce court or mediator deems fair and equitable.
For this case study, Cassandra and Allen have been married for 27 years, were each 26 years of age when they married, have only been married once and live in an equitable division state. They have three adult children from the marriage: Sam, 25; Josh, 23; and Alisha, 20, making child support a non-issue. However, spousal maintenance, or alimony, is a financial issue in this divorce case, but is beyond the scope of discussion in this article.
Both partners have worked during the marriage. Allen has been a highly compensated executive at two Fortune 500 companies and is currently a senior vice president of operations at a publicly held corporation, with an annual salary of $295,000. The family has moved six times in the 27-year marriage because of Allen's career. His 401(k) has a vested value of $465,000, three vested pension plans with current and former employers and a Rollover IRA worth $465,000.
Cassandra's career has been flexible and part-time because the couple decided that Allen's high-paying jobs would take priority, and Cassandra chose jobs with flexible hours while the children were in school. She worked part-time as a speech therapist in a private clinic for each of the six moves and contributed to 401(k) plans when available. Her current 401(k) is worth $25,000, is vested, and her Rollover IRA account is valued at $125,000. They both have Roth IRA accounts that are of equal value.
Allen will begin receiving monthly pension payment from all three funds at age 65. Cassandra has no current pension plan, having rolled over all previous pension balances into a Rollover IRA. She inherited $100,000 from her mother, and Allen inherited $75,000 from his parents. Each of the inheritances were kept in separate accounts, were never commingled, and dividends and interest were reinvested in the each account and no distributions were made.
Marital homes have been bought and sold during the course of the marriage. They currently own a marital home that has a market value of $1.5 million, with a cost basis of $1 million, and a first mortgage of $150,000.
The couple owns a joint account that has $500,000 of marketable securities, which include tax-free bonds, individual stocks and various mutual funds. Again, no distributions were made from this account and both husband and wife made contributions.
Personal belongings are also valued and divided, but discussion of this issue is beyond the scope of this article. There are credit cards, held jointly, but the balance is paid off in full on a monthly basis.
During the divorce process, the first step in dealing with the assets is to determine which assets are separate or marital property. Any asset is identified as separate property if it was owned prior to the marriage, or inherited or gifted during the marriage. Allen's inheritance of $75,000 and Cassandra's amount of $100,000, which were inherited during the marriage, are considered separate property and not subject to division during the divorce process.
The balance of the marital assets needs to be grouped according to the type of account: 401(k)s and Rollover (pretax) IRAs in one category; Roth IRAs; and after-tax accounts. According to Section 1041 of the Internal Revenue Code, the general rule in dividing assets in divorces with property settlement agreements (PSAs) is that transfers of ownership between spouses can be completed without any federal income or gift-tax consequences. When an asset qualifies for the tax-free transfer rule, the spouse who receives the asset also uses the existing holding period (the original date of ownership) and existing tax basis (for capital gain or loss) for when the transferred asset is sold in the future.
Allen's current 401(k) of $465,000 and Rollover IRA of $1,200,000 totals $1,665,000, while Cassandra's Rollover IRA account of $125,000 and current 401(k) value of $25,000 equal $150,000. Because these four accounts have pretax dollars, the totals of $1,665,000 and $150,000 can be divided according to the negotiations and PSA. Dollars can be transferred from a 401(k) to an IRA or from an IRA to an IRA account without any tax consequences or penalties. A qualified domestic relations order (QDRO) is a document, separate from the PSA document, which directs the current third-party administrator of an ERISA account to transfer dollars or a specific percentage to an IRA account. A QDRO is not needed to transfer dollars from one spouse's IRA to the other spouse's IRA, but any transfer of IRA dollars has to be mentioned in the PSA in order for the transfer to be tax- and penalty-free.
The Roth IRA accounts are of equal value, and need to be mentioned in the PSA but do not need any dollars transferred from one account to the other.
The joint account can be divided between the two spouses or held by one and offset by equity value in the marital home or other after-tax marital assets. When the joint account is divided, it is important to identify the cost basis of each asset and to take future capital gain taxes into consideration as the joint account is divided. A pretax asset can often offset an after-tax asset, but the tax consequences need to be taken into consideration and calculated prior to the final signing of the PSA.
The marital home, being valued at $1.5 million with a cost basis of $1 million, is in joint name. It is advantageous to keep the house in joint name if the home is to be sold to capture the $250,000 capital gain exclusion allowed for each spouse. Otherwise, if the marital home is transferred to one spouse and later sold, it would have a capital gain exclusion of only $250,000 with the other $250,000 being a taxable capital gain consequence for the spouse who receives the marital home in the divorce settlement. The cost basis is a nontaxable transfer upon divorce.
Each of Allen's three pension plans is a marital asset and will be divided by three QDROs—one written for each pension plan. Each QDRO document will state the percentage or dollar amount of the pension that will be transferred on Cassandra's behalf, within each of the three respective pension plans, and when the pension payment can start for Cassandra.
Understanding the tax implications of transferring marital assets can be a key element in successfully negotiating settlements. Beyond merely understanding the rules, helping your clients with strategies to avoid unnecessary taxes and penalties can be a significant cost saving to them.
Darlys S. Harmon-Vaught, Ph.D., CDFA, CFFA, CFE, CTS
is a divorce financial analyst and owner of
Financial Solutions for Divorce in Louisville, Ky.
She can be reached at (502) 657-6081 or
this email address or www.dshv-cdfa.com.
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