Taxpayers’ tax liabilities could be drastically changed after a divorce. However, when a couple is contemplating a divorce, a discussion with their lawyers and tax advisors related to tax implications of their divorce could greatly help in controlling the tax consequences. The tax consequences resulting from a divorce have changed for tax years 2018 and later because of the Tax Cuts and Jobs Act of 2017 (TCJA).
As a general tax rule, in a divorce taxpayers can divide up most assets, including cash, between you and your soon-to-be former spouse without any federal income or gift tax consequences. When an asset falls under the tax-free transfer rule, the former spouse who receives the asset takes over its existing tax basis for tax gain or loss purposes and its existing holding period.
If your business has a qualified retirement plan, such as a profit-sharing plan, 401(k) plan, or defined benefit pension plan, you probably will be required to give your soon-to-be former spouse a percentage of your account balance or benefits as part of the divorce property settlement.
You need to make the transfer to your former spouse without putting yourself on the hook for income taxes on amounts that go to your former spouse. You would include a qualified domestic relations order (QDRO) in the divorce papers.
A QDRO is “a judgment, decree, or order relating to payment of child support, alimony, or marital property rights to a spouse, former spouse, child, or other dependent of a participant in a retirement plan. The QDRO must contain certain spe-cific information, such as the name and last known mailing address of the participant and each alternate payee, and the amount or percentage of the participant’s benefits to be paid to each alternate payee. A QDRO may not award an amount or form of benefit that isn’t available under the plan. A spouse or former spouse who receives part of the benefits from a retirement plan under a QDRO reports the payments received as if they were a plan participant. A distribution that is paid to a child or other dependent under a QDRO is taxed to the plan participant”.
The QDRO makes your former spouse responsible for the income taxes on retirement account money that he or she receives in the form of account withdrawals, a pension, or an annuity. In other words, the QDRO causes the tax bill to follow the money.
You do not need a QDRO to obtain an equitable tax outcome when you are required to turn over some of your IRA money to your former spouse as part of a divorce property settlement. QDROs are only relevant in the context of qualified retirement plans. Therefore, you do not need a QDRO for your Simplified Employee Pension accounts, Savings Incentive Match Plan for Employees IRAs, traditional IRAs, and Roth IRAs. However, a spouse must be careful and use the magic words to avoid getting taxed on money that goes to your former spouse.
You can make a tax-free transfer of all or a portion of an IRA balance to your former spouse only if the transfer is ordered by a divorce or separation instrument. For this purpose, the tax code narrowly defines a divorce or separation instrument as a “decree of divorce or separate maintenance or a written instrument incident to such a decree.”
The federal income tax deduction for alimony payments required by divorce agreements executed after 2018 was permanently eliminated by the TCJA. If you are a higher-income individual, this change is costly to you. What could you do now that those deductions have been eliminated? A tax strategy is to transfer assets with tax liabilities to your soon-to-be- former spouse (such as qualified plan and IRA balances, appreciated stock and mutual fund shares, and ownership of your highly appreciated assets).
Disassociating yourself from tax liabilities is effectively the same as getting a tax deduction.
Further reading. See IRS Publication 504, 575.
Hiring a tax resolution expert is the best action a taxpayer could take in a tax matter before the IRS or a state tax authority.
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