Divorce Tax Consequences Under New Federal Tax Laws
As with all financial transactions, divorce comes with tax consequences. And those consequences have changed for tax years 2018 and later thanks to the Tax Cuts and Jobs Act (TCJA).
The general tax rule in a divorce is that you can divide up most assets, including cash, between you and your soon-to-be ex-spouse without any federal income or gift tax consequences.
When an asset falls under the tax-free transfer rule, the ex-spouse who receives the asset takes over its existing tax basis (for tax gain/loss purposes) and its existing holding period (for short- or long-term holding period purposes).
Example. Your divorce settlement calls for your soon-to-be-ex to get 40 percent of your highly appreciated small-business corporation stock. Thanks to the tax-free transfer rule, there’s no tax impact when you transfer the shares.
Your ex keeps on rolling under the same tax rules that would have applied had you continued to own the shares (carryover basis and carryover holding period). When your ex ultimately sells the shares, he or she (not you) will owe any resulting capital gains taxes.
Does your business have a qualified retirement plan, such as a profit-sharing plan, 401(k) plan, or defined benefit pension plan? If so, you probably will be required to give your soon-to-be-ex a percentage of your account balance or benefits as part of the divorce property settlement.
The trick is to do this without putting yourself on the hook for income taxes on amounts that go to your ex. Here’s the drill: include a qualified domestic relations order (QDRO) in the divorce papers. The QDRO makes your ex 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, which is only fair.
QDRO Not Required
You don’t need a QDRO to obtain an equitable tax outcome when you are required to turn over some of your IRA money to your ex as part of a divorce property settlement. QDROs are only relevant in the context of qualified retirement plans.
Therefore, you don’t need a QDRO for your Simplified Employee Pension accounts, Savings Incentive Match Plan for Employees IRAs, traditional IRAs, and Roth IRAs. Even so, you have to be careful and use the magic words to avoid getting taxed on money that goes to your ex.
Avoid the tax problem: include magic words in the divorce papers.
You can make a tax-free transfer of all or a portion of an IRA balance to your ex 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.”
TCJA Eliminates Alimony Tax Deduction
How do you counteract loss of alimony deductions? 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 TCJA post-2018 development is an expensive game-changer for you. In the pre-TCJA days, you as a higher-income individual could reap big tax savings from deducting alimony payments, but those tax savings are now history.
What can you do now that those deductions have been eliminated?
One thing is to transfer assets with tax liabilities to your soon-to-be-ex (such as qualified plan and IRA balances, appreciated stock and mutual fund shares, and ownership of your highly appreciated vacation home).
Disassociating yourself from tax liabilities is effectively the same as getting a deduction. In a divorce, make it your mission to try to keep ownership of assets that have no tax liabilities, such as your Roth IRA.
If your business is incorporated and your soon-to-be-ex is a part owner, another idea is to arrange for a stock redemption deal to buy out your ex’s shares in lieu of making nondeductible alimony payments. With proper planning, you can arrange for your ex to bear the tax consequences of the redemption.