One of the most important things to consider when negotiating a divorce is the disparate tax treatment of different savings vehicles. Offering up $70,000 in a standard 401(k) or IRA is not the same as offering up $70,000 in equity in a home, or $70,000 in a Roth-IRA or a basic savings account, or even agreeing to assume $70,000 in debt. As anyone who has attempted to spend money from a retirement account can tell you, a dollar is not always worth a dollar. Let’s go through some of the basic scenarios.
Savings Account or Checking Account
Savings and checking accounts are the ham and egg of savings vehicles. Other than some interest obtained in a savings account, what you see is what you get. There will be taxes on the interest obtained but otherwise your money is your money with only negligible tax impact. As you can see in other examples, below, you must be careful in trading such low tax impact assets for other assets with potentially large tax exposures.
Stocks in Taxable Accounts
Stocks held in “taxable” accounts, i.e. not retirement funds, are generally only taxable at the time they are sold, and then only if they are profitable. Accordingly, if you sell $10,000.00 of Google stock in a taxable account, the federal government will look for the base, or how much you paid for the Google stock at the time of purchase. If you paid $6,000.00, then that means you will be taxed on the $4,000.00 profit you made.
If you have another stock you sold at a $3,000.00 loss, you can even ‘wash’ the transactions against each other and create no stock impact. You can also carry forward losses in the amount of $3,000.00 each year to be used against gains in future years. So, when negotiating a divorce, keep in mind that if you agree to take stock held in a taxable account, that you will be taxed on any gains at the time of sale, or that you may even be able to bank some losses and use that as a tax offset to your future advantage. Don’t forget that dividends or other forms of capital gains will also be taxed.
Retirement Accounts including 401(k)’s and IRA’s
Everyone loves having a large retirement account, but keep in mind the potentially large tax exposure and other limitations involved with these types of assets. With 401(k)’s or IRA’s, you are essentially deferring tax from the year you make the contributions until the year you actually withdraw the money.
So, if you and your spouse contributed $20,000.00 to your respective 401(k)’s in 2024, that means $20,000.00 would be reduced from your tax exposure for that year’s tax returns. The idea is to defer taxes from the present, when you are earning a higher income, to the time you are retired, when your income is likely to be reduced. Meanwhile, your assets contained within your retirement vehicles continue to grow, tax-free, during the period of time until sale. That means that any dividends received will also not be taxed in the year of receipt. All a great deal, in theory, but with various restrictions.
59 1/2 Rule
Namely, you must keep the money in the retirement account until you are 59 ½ years old. If you withdraw prior to that age, it is considered an early withdrawal, and you are penalized 10% of the withdrawn amount. So, if you withdraw $60,000.00 at the age of 55, then you will need to pay the federal government a penalty of 10%, or $6,000.00. You will also need to then pay taxes on the $60,000.00 at your income tax rate. On $60,000.00, that could be another approximately 30% hit, or $18,000.00.
Suddenly, the $60,000.00 you thought you had is paid out, once tax-effected, in the final sum of only $36,000.00. And even if you made it to 59 ½ before withdrawing, you would only have $42,000.00. Clearly, a far cry from the (largely) unrestrained withdrawal of funds from a savings or checking account. Accordingly, if you are going to negotiate across asset classes, you have to keep this in mind so that when you are trading apples to oranges, you tax impact everything to make sure you get a square deal.
Please note that there may be certain exemptions to the taxes or penalty, such as paying for a college education, or a first home, or in certain hardship scenarios, but same are outside the scope of this section. As always, consult with an accountant or tax attorney to be certain of tax implications, particularly as the tax laws are always changing.
Real Estate
Real estate also carries with it certain tax implications. As well as remembering all of the closing costs and real estate commissions that will eat into the value of the asset. Luckily, the first $250,000 for single filers (or $500,000.00 for those filing jointly as a married couple) are exempt from federal capital gains taxes. This exemption is only allowed once every two years. This exemption also only applies to your primary residence, so it would not apply to a vacation home. The IRS considers a “principal” home one that you have resided in for at least two of the last five years. You can also avoid taxes with a “like-exchange” of purchasing another, similar primary residence with the proceeds. Accordingly, there are tax implications for real estate, but they are somewhat muted in most instances, particularly for the primary residence.
Roth IRA
You can think of the Roth IRA as the inverse of the standard, or traditional IRA. Here, you do not defer any taxes, but you can later withdraw the Roth IRA funds without a tax impact. As you are paying with post-tax dollars, you are not required to pay taxes upon withdrawal. However, you would still be required to pay a 10% penalty on a Roth IRA if you withdraw prior to age 59 ½ or if you do not hold the funds for five years. Either of these scenarios would trigger the 10% penalty to the IRS.
Like with a Traditional IRA, you will also be hit with minimum required withdrawals once you reach standard retirement ages, which will also limit your ability to maneuver. This, too, should be considered when negotiating your divorce agreement.
Debts/Liabilities
Sometimes, a liability can be an advantage. For instance, if you have $70,000.00 in marital debt, meaning ½ or $35,000.00 of it would be considered your debt, legally (in most instances), then it may not seem like a win when you trade off $35,000.00 in an IRA for your spouse paying off your portion of the $35,000.00 owed, but once tax-effected, it would be. The $35,000.00 will carry no tax impact if paid by your spouse, whereas the $35,000.00 in the IRA would be heavily taxed if withdrawn. Although there are other considerations, of course, such as the interest rate on the debt verse the expected rate of return on the retirement funds, this proves that outside the box thinking can be a valuable tool in divorce negotiations.
Conclusion
As you can see, there are many tax implications that can complicate divorce negotiations. By being sophisticated to these differences, you can ensure that you gain a fair or better deal. Although tax implications are not the only thing to consider when negotiating asset classes, or even debts/liabilities, they are an important piece of the divorce puzzle.