Divorce and Taxes
Divorce tax planning is important when dividing assets. Whether you are giving up or receiving assets you need to understand the tax consequences. Yes, divorce and taxes go hand in hand. It is essential that you plan which party will be responsible for which taxes. Be proactive. Knowing the proper language to use in the documentation is key. Some things to discuss during your divorce include IRAs and a Qualified Domestic Relations Order.
The good thing about divorce tax is that IRA to IRA transfers are usually tax free. Also, Qualified distributions from Roth IRAs are tax-free. If you receive a distribution from an IRA as part of your divorce settlement, rather than an IRA-to-IRA transfer, you will have 60 days to reinvest or “rollover” that distribution to your own IRA. However, 20% of that distribution will be withheld for taxes (as an offset to future income tax liability). The individual who gives up the assets is usually not responsible for any tax or penalty of any subsequent distribution that occurs. The former spouse will treat the assets as his or her own IRA and will be responsible for any taxes and penalties resulting from subsequent distributions. The IRA holder will owe federal income taxes plus a 10% penalty on the transferred amount if the IRA transfer rules are not followed. Thus, the IRS could rule that such a transaction be treated as a distribution to the spouse who gave up the assets. Remember, if the IRA includes nondeductible assets, both parties will need to inform the IRS of the change in ownership. Filing of Form 8606 is important in helping to prevent the former spouse from paying taxes on distributed assets that should be tax free.
Qualified Domestic Relations Order
Divorce tax gets a little more complicated with QDRO. A QDRO is a legal document or a provision included in another legal document. One example of a QDRO is a divorce-related property settlement or divorce decree. The QDRO establishes the right of a former spouse to receive all or part of the other former spouse’s qualified retirement plan benefits and pay the income taxes on those benefits. So, basically, the person that receives the money pays the taxes. QDRO’s are not needed to transfer IRAs from one spouse to another spouse. Funds from one spouse’s IRA can be rolled over tax-free into an IRA set up by the other spouse as long as the settlement agreement specifies it. Sounds complicated? It can be. That is the main reason why divorce tax planning makes sense. Do you really want to be surprised with a big tax bill? At the very least, you may decide to negotiate a different settlement amount now that you know who pays what taxes.