Stocks and Bonds, Capital Gains
As a general rule, the transfer of property from one spouse to the other is free of taxes when done because of divorce; but without considering tax ramifications, a 50/50 division could seem to be fair, when it is not. Be sure to work this out with a specialist in divorce financial planning to understand the long-term outcome.
401k Plans (Savings Plans, Profit Sharing, 403b)
There are some special rules governing the transfer of property in the form of distributions from these plans during the divorce that permit the non-employee spouse to withdraw funds from the account without paying a penalty, in spite of being under age 59 ½.
For instance, assume Connie is to get half of Brian’s 401k account presently worth $500,000. She can transfer that $250,000 to her own IRA which is a non-taxable event. But assume Connie needs some cash to pay her attorney. Normally, there is a 10% penalty as well as ordinary income tax on withdrawals from a qualified plan prior to age 59 ½.
Using this special exception when the plan is divided pursuant to divorce, if she needs $8,000, she will have to ask for $10,000. The plan will withhold $2,000 income tax (20%) and send $8,000 to her. She can then transfer the remaining $240,000 to her IRA. She secured funds for attorney fees and saved the 10% $1,000 penalty.
This exception does not apply to IRAs.
Remember only the “alternate payee” is entitled to the exemption from the early withdrawal penalty of 10% in such transfers of property.
The Pension benefit can be divided two different ways. The “shared interest” approach means that they wait until the participant’s retirement to divide the benefit. This is the least desirable method.
The “separate interest” method provides for the alternate payee to have her own account set up with the pension plan wherein she can access her share based on her own life expectancy and age.
Some pension plans provide a currently vested lump sum value for the pension. If so, this is the figure used in asset division. Some plans provide only a money benefit to be paid at some time in the future. However, it can be valued with a two step process.
Calculate a present value of the monthly or annual benefit available at his normal retirement age, usually age 65. We use the IRC life expectancy tables for the number of years of pension receipt and the 30-year treasury rate for the discount rate.
Use a separate calculation, using the above answer as the present value, solving for the present value of that sum, where the number of years equals 65 minus the participant’s age.
This creates the value used on the spreadsheet when dividing assets. If divided 50/50, the value is irrelevant. However, we frequently use the offset method, determining the present value for the pension and allocating an equivalent asset to the other spouse.
While we understand the reduction of a pension for early receipt, also be aware of the “Early Retirement Subsidy”. If the “alternate payee” is to receive a portion of a pension and takes it prior to the participant’s retirement, she will not be entitled to the early retirement subsidy. This could be a large percentage of the pension. Ideally, if not taking an offsetting asset, it’s best for the alternate payee to wait until the participant’s retirement to access the benefit.
IRA’s can be divided or the ownership can be transferred at divorce without a QDRO. Typically the plan administrator will need to see a certified copy of the divorce decree.
Rules differ for taking money out of an IRA. Remember that an individual could take a penalty-free distribution from a 401k when rolling over to his IRA from a 401k? Well, if she wants to pull more cash out of the IRA, she will have to pay the 10% penalty, but there will not be any 20% withholding by the company. Yes, she still has to pay taxes on her withdrawal based on 1040 calculations.
Most executive bonuses are paid following the end of a year of service and are based on performance and other factors during the preceding year. Even if this bonus is received in March of 2010 and the couple is divorced in January of 2010, in Texas, it is considered 100% community and subject to division. If they were married for a partial year, the bonus is prorated to determine the community share.
Sometimes a signing bonus is provided when the executive accepts a position. For this situation, it is necessary to review the employment contract to determine whether the bonus is given for future services. For instance, if the contract requires the husband to work five years or else repay a pro-rata portion of the bonus, it could be argued that a portion is to be earned in the future and is not divisible during divorce. Without the chance of forfeiture, it would be difficult to overcome the presumption that the bonus was just a reward for executing the contract. The executive should consult an attorney for guidance.
The division of assets during divorce is complicated by the tax liabilities associated with different assets, but by shifting assets and income streams between divorcing spouses, the tax code can be used to their advantage. Divorcing individuals should educate themselves about transfer of property and divorce financial and tax issues in order to make the best possible decisions during this stressful time of life.
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