Tax Planning when the Accounts Have to Be Divided
Tax planning in a separation is one area where it makes a difference whether you are divorcing after a marriage or ending a long-term partnership. Spouses have legal rights that partners don't. The federal tax code was written with this in mind. In either case, it's important to understand the after-tax value and the true current value of the assets you're dividing to be sure you get your fair share.
Calculating After-Tax Value
After-tax value is the amount of money left over after selling an asset or liquidating an account, then paying taxes owed on the proceeds. Check Chapter 16 to review the different types of taxes that affect your assets. Remember, ordinary income is taxed at a higher rate than capital gains or profits on investments. These rates change based on your total income and filing status (married or single, for example). Check
How does the alternative minimum tax work into the after-tax calculations?
The AMT laws are very complex. If you have a number of deductions such as mortgage interest and dependents, or a complex tax situation that involves things such as stock options or a small business, you should ask your CPA to help with the after-tax valuations.
Retirement accounts, such as an IRA or a 401(k), are tax deferred. This means that the money in them isn't taxed until it's withdrawn. The amount withdrawn from a retirement account is taxed as ordinary income to the person who owns it. In a divorce, spouses can direct in the final divorce decree that money from one person's retirement account be moved into the other's account. This transfer under a Qualified Domestic Relations Order, or QUADRO, takes place after the divorce is final. Since the money moves from one spouse to the other, it isn't taxable. If you can QUADRO the account, the after-tax value would be the same as the current value, because there's no tax when the money is transferred.
If the ex-spouse receiving the money decides to take the cash rather than a transfer of assets directly into his IRA, then the amount is taxed as income to him. The after-tax value of the account would be the value less the tax they owe, in this case. Spouses don't pay the 10 percent early withdrawal penalty if they receive money from an IRA through a QUADRO.
None of these tax-deferred transfer benefits are available to nonspouses. For unmarried partners, the after-tax value of the account is the value less the tax due, less the early withdrawal penalty of 10 percent if your partner is under age 59½.
The after-tax value of nonretirement accounts doesn't hinge on whether you're a divorcing spouse or a separating partner. It is the value of the account less any capital gains taxes due on investment profits. Unmarried partners must beware of gift tax problems when transferring money from one ex-partner to another. There is a limit — $12,000 in 2008 — that you can transfer between unmarried people per year.
Valuing Nonliquid Assets
Nonliquid assets are tougher to decipher because they don't issue regular account statements showing their value. Start with an appraisal or a reliable estimate of the value, and then subtract the cost of selling the asset — regardless of whether you plan to sell after the separation. To get after-tax value, from net value subtract any capital gains taxes that would be due because the asset appreciated since purchase.
Valuing Income Streams
An example of an income stream is the regular payments from a pension. The total potential proceeds from a pension are usually higher than the amount available if the pension is cashed out in a lump sum. This is the reason that many people opt to receive the payments instead of cashing out the pension. It's also the reason you can't rely on the current account value when you're valuing a pension in a separation.
Calculate the present value of the future pension payments using a spreadsheet program or a financial calculator. Your financial planner or accountant can help you with this, as well.
Value of a Career
Putting a value on the ability to work for an income each year is more difficult than valuing an income stream from a pension. Often, one person in a couple puts a career on hold to raise children or otherwise support the family's lifestyle. When you separate, it's important to consider the value of this work — even though it went unpaid. Compare the two partners' future income potentials. Calculate the present value of the difference between the two, and see what you get. Many people feel guilty about receiving alimony from an income-earning spouse after a long marriage spent raising kids. This present value comparison of ability to earn can be a very large number and might make you feel differently about making sure you get enough future support to help you get back on the career track.
