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Divorce & Taxes

February 22, 2021 by Melissa (Missie) Beach

Quick question: Do you want the $100,000 bank account earning 0.01% interest or the brokerage account with $100,000 of Tesla stock that went up 740% in 2020?

Answer: Choose the cold, hard cash in the bank and run!

When splitting assets in a divorce, $100,000 is not always $100,000. The bank account with the paltry interest rate might seem unattractive compared to the brokerage account with the hot stock that has been on a tear, but there are tax consequences to consider. A bank savings account does not have a gain, as you’re taxed yearly on that minimal interest income it generates. However, a stock that has risen in value has a capital gain that generates a tax liability when it’s sold. For example, if you bought a stock for $10, held it for over a year, and then sold it for $100, you would owe capital gains tax on that $90 of gain ($100 – $10). Federal capital gains rates range are 0%, 15%, or 20% depending on your income. State tax also applies. Suddenly, your $100,000 account is no longer $100,000 after you pay capital gains taxes.

Retirement accounts also require special consideration when it comes time to split. 401(k)s, 403(b)s, IRAs, etc., don’t allow for distributions without penalty until the account holder turns 59 ½ once the initial divorce occurs. In addition, these accounts are funded with pre-tax dollars and are taxed upon distribution. Therefore, a $500,000 IRA isn’t worth $500,000. It’s worth $500,000 less whatever ordinary income taxes are due upon distribution at retirement age.

When deciding who gets the primary residence, keep in mind the amount of gain the family home has incurred. If the family has lived in the home for a long time, when the spouse who retains the residence goes to sell it, she or he will only get to exclude $250,000 of gain (not the $500,000 a married couple does) from taxation and must pay capital gains tax on the remainder of the gain. It might make sense to liquidate the family home and start over so the recognition of the gains are split at the time of the divorce.

Divorce is stressful enough. Divorce attorneys are knowledgeable about the law, but it is always good practice to involve your financial advisor and CPA during the process before the agreement is finalized. Running long term cash flow projections is helpful to ensure that both sides come out with a fair outcome.

 

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