Divorce involves more than dividing property and determining support payments. The tax consequences of your settlement can have a significant impact on how much you ultimately keep.
Retirement accounts deserve particular attention. A $500,000 retirement account doesn’t necessarily have the same after-tax value as $500,000 in cash or a Roth IRA. And transferring retirement assets incorrectly can create an unexpected tax bill—or even an early-withdrawal penalty.
As part of your divorce tax planning, it’s important to understand how retirement accounts can be divided and how to structure those transfers properly.
Dividing IRAs in a Divorce
Traditional IRAs, Roth IRAs, SEP IRAs and SIMPLE IRAs generally can be transferred between divorcing spouses without immediate federal income tax consequences.
The key is how the transfer is structured.
A transfer of all or part of an IRA to your former spouse can generally be made tax-free when it is required by a divorce decree, separate maintenance decree or qualifying written instrument related to the divorce. The IRA custodian can typically transfer the assets directly to an IRA in your former spouse’s name or change the ownership of the existing account.
Once the transfer is complete, the receiving spouse generally becomes responsible for any taxes associated with future taxable distributions.
Don’t Transfer IRA Funds Informally
One of the biggest mistakes is taking money out of an IRA and giving it to your spouse outside the terms of the divorce agreement.
That can be treated as a taxable distribution to you—even though your former spouse receives the money. If you’re under age 59½, an additional 10% early-distribution tax may also apply unless an exception is available.
The lesson is simple: don’t move retirement funds until the transfer has been properly addressed in your divorce documents and coordinated with the account custodian and your advisors.
401(k)s and Other Employer Retirement Plans
Retirement plans through an employer, such as 401(k)s and pension plans, generally follow different rules.
A Qualified Domestic Relations Order (QDRO) is commonly required to divide benefits under these plans.
A QDRO establishes your former spouse’s legal right to receive a portion of your retirement account or pension benefits. It also helps ensure that your former spouse—not you—is generally responsible for income taxes when they receive taxable distributions.
Depending on the plan, your former spouse may also be able to roll an eligible distribution received under a QDRO into an IRA without immediately paying income tax.
Why a QDRO Matters
Without a properly executed QDRO, a transfer from an employer-sponsored retirement plan can potentially be treated as a taxable distribution to the employee who owns the account.
That could leave one spouse with the money while the other spouse is responsible for the tax bill.
A large taxable distribution could also increase taxable income enough to affect other income-based tax benefits or potentially trigger additional taxes.
Because QDRO requirements can vary by plan, it’s important to coordinate with the plan administrator and qualified legal and tax professionals before making a transfer.
Look at After-Tax Value, Not Just Account Balances
When negotiating a divorce settlement, it’s tempting to compare assets based on their current account balances.
But $500,000 in a traditional 401(k) isn’t necessarily equivalent to $500,000 in a bank or investment account.
Traditional retirement accounts generally contain money that hasn’t yet been taxed. Future taxable withdrawals may reduce the amount you ultimately receive.
Roth retirement accounts are different. Qualified Roth distributions are generally tax-free because contributions were made with after-tax dollars.
That means the tax treatment of each asset should be considered when determining whether a proposed settlement is truly equitable.
For example, one spouse might retain a traditional 401(k) while the other receives a taxable investment account or other marital asset. The balances might look equal on paper, but their future tax consequences could be very different.
Other Assets Can Have Tax Consequences, Too
Retirement accounts aren’t the only assets where taxes matter.
In many divorces, marital assets—including real estate, investments, cash and business interests—can generally be transferred between spouses without immediate federal income tax consequences when the transfer qualifies as incident to divorce.
However, the receiving spouse generally takes on the asset’s existing tax basis.
That means an asset that looks valuable today could carry a significant future tax liability.
For example, if one spouse receives highly appreciated stock with a low tax basis, they may owe capital gains tax when the investment is eventually sold.
The right question isn’t always “Who gets the asset?” It’s “What is this asset really worth after considering future taxes?”
Build Taxes Into Your Divorce Settlement
Divorce can be financially complicated, particularly when spouses have accumulated significant retirement savings, investments, real estate or business interests.
Before finalizing a settlement, consider:
- How will each retirement account be taxed when distributions are taken?
- Does a retirement account transfer require a QDRO?
- Are the assets being compared based on their after-tax value?
- Could a proposed distribution create an unexpected tax bill or penalty?
- What tax basis will transfer with investment property or other appreciated assets?
- Are there state tax considerations that should be addressed?
Working with your attorney and tax advisor early in the process can help you evaluate different settlement scenarios before the terms are finalized.
Plan for the Tax Consequences Before You Sign
A divorce settlement is about more than dividing assets today. It’s also about understanding how those assets may affect your financial position in the years ahead.
Retirement accounts, investment assets and business interests can all carry different tax consequences. Properly structured transfers can help avoid unnecessary taxes and penalties, while considering after-tax values can help you make a more informed decision about the overall settlement.
Divorce tax planning is most valuable before the settlement is finalized—not after a costly tax issue has already occurred.
If you’re going through a divorce involving significant retirement or investment assets, talk with your tax advisor before signing the final agreement. Understanding the tax implications now can help you avoid unpleasant surprises later.