Divorce Can Be Very Taxing if You’re Not Careful
Elizabeth Taylor and others who have been to the altar--and to divorce court--many times may skew the statistics somewhat, but experts maintain you’ve got a 50-50 chance of getting divorced at least once in your lifetime.
That’s because about 1.2 million couples get divorced each year, according to the U.S. Department of Health and Human Services. So every year you’re married, your divorce chances increase a touch.
Financial advisers maintain that divorce can impoverish or enrich you. Generally speaking, divorce enriches husbands and impoverishes wives, according to government analysts.
Surprisingly, some inequities are inadvertent. Divorce lawyers say many couples attempt to split their marital assets 50-50, for example, but they frequently fail because they don’t consider the tax ramifications of the split.
“Every asset you are dividing has tax baggage that goes along with it,” says Daniel J. Jaffe, partner at the law firm of Jaffe & Clemens in Beverly Hills. “There’s $1 million in the bank and $1 million in the pension plan. When you take the money out of the pension plan, you have to pay 40% tax, so you really only get $600,000. The other spouse gets $1 million.”
However, couples who pay attention to taxes can not only even the score, they can retain more of their assets by making Uncle Sam take less. In the end, both husband and wife can be better off.
Consider what happens to Sally and Steve Gonzalez, a hypothetical incompatible couple who have $150,000 in retirement savings and $150,000 equity in a home. They want to divide their assets in half, so he takes the retirement account and she takes the house.
An even split? Hardly.
If she decides to sell the house and doesn’t roll the gain into a home of equal or greater value, she’ll owe tax on the sale. (If she continues to roll her gain into equal or more costly residences, her gain stays “tax deferred” indefinitely.) But she’ll only pay tax on the net profit--the difference between the selling price and the cost of the home, plus any improvements they’ve made over the years.
For example’s sake, let’s say the net profit is $50,000. If she pays 28% in federal tax, she’ll owe $14,000. The after-tax value of her portion of the property is $136,000.
Steve isn’t so lucky. Every dollar he takes out of the retirement account is taxable. If he takes it out before he’s 59 1/2, he’ll probably pay a 10% excise tax as well. Assuming Steve is in the 28% tax bracket when he starts withdrawing the funds, he’ll pay a total of $42,000 in federal tax. He ends up with $108,000--$28,000 less than his wife.
The implications are equally dramatic when the couple is simply splitting the retirement account. If Steve gives Sally a check for half of the $150,000, she gets $75,000 tax-free. He ends up paying tax for both of them and nets out only about $33,000.
If the only goal is to make the split equal, Steve could simply pay Sally less when they divide the retirement account. But they can lower their total tax obligation by restructuring the deal, Jaffe says.
Let’s say Steve wants to buy Sally’s portion of the retirement account. Instead of writing her a check for $54,000 ($75,000 minus the estimated tax of $21,000) and calling the payment a property settlement, he could pay her the entire $75,000 over time, plus interest, and call the payments alimony.
What’s the difference? Payments in a property settlement aren’t tax deductible to the payer, nor taxable to the receiver. If the payment is called alimony, it is deductible to the payer and taxable to the receiver. Assuming Steve is in a higher tax bracket than Sally--as is often the case--they can both make out nicely on the deal.
Let’s say Steve pays Sally her portion of the retirement fund over a four-year period, calling the payments alimony. Because he’s not paying the whole amount right away, he’s going to give her 5% interest on the obligation. He’ll make 48 monthly payments of $1,727.20, which gives Sally $82,905. Steve is in the highest federal tax bracket, so he got a 31% tax deduction for alimony payments. That saves him $25,700 over the four-year period.
Sally, on the other hand, is in the 15% tax bracket, because her only income comes from Steve’s alimony payments, which amount to less than $21,000 annually. Assuming tax rates stay constant, she’ll pay less than $9,000 in tax over the four years because she is able to use personal exemptions and standard deductions to offset the income.
Together Steve and Sally have come out some $16,700 richer by doing the deal this way.
However, there is a catch. If alimony payments drop off substantially within three years of the divorce, the IRS will assume that the alimony was actually a property settlement in disguise. That will cause them to disallow Steve’s deductions. Sally will get a deduction for the deductions Steve lost that year, but because of the way the tax rules work, it may not even out, said Philip J. Holthouse, partner at the Los Angeles accounting firm of Holthouse Carlin & Van Trigt.
You must also make sure that the payments are not dependent on circumstances related to your children. For instance, you can’t stop making alimony payments within a few months of your child leaving home or turning legal age because the IRS will consider such payments child support, which is also not deductible.
Finally, couples who are splitting assets should also be aware of potential time bombs such as faltering tax shelters, Holthouse said.
When a tax shelter goes sour, limited partners can get hit with “recapture” of past deductions, he notes. If you’ve invested in limited partnerships in the past, you may want to specify in your divorce agreement who gets the tax headaches if and when they arise.
