In the United States, a couple divorces every 36 seconds. While plenty of marriages do last, when a marriage ends, it’s a huge financial shift for both partners. On May 12, Advice Chaser will host a webinar titled “Avoid Financial Errors in Divorce Settlement,” featuring certified divorce financial analyst Wesley Bangs. This webinar is a must-see for anyone going through a divorce and worried about finances.
Income Sources in Divorce
In a divorce, partners separate their finances as well as their personal life. But money might pass between them in three ways: child support, alimony (also called spousal support), and the division of marital property.
Child support tends to be predictable, depending on the requirements of the state you live in. The court will consider factors such as the number of children, how much time they spend with each parent, and who is paying for larger costs like insurance. Child support is usually not taxable to the recipient.
Spousal support, on the other hand, can vary widely based on what each spouse earns and the length of the marriage. If both spouses make a similar income and the marriage only lasted a few years, there may be no alimony at all. But if one spouse can’t work, the alimony, combined with child support, may go as high as half of what the other spouse earns. Courts will sometimes impute earnings based on a person’s ability to earn, rather than their actual paycheck, if they believe the person is deliberately not working in order to deprive their former spouse.
Unlike child support, alimony used to be taxed on the recipient’s end. But the payer could usually deduct the amount on their taxes. That changed due to the Tax Cuts and Jobs Act, but only for divorces finalized during or after 2019. Now, alimony payments are treated like child support—neither tax-deductible for the payer nor taxed for the recipient—unless you were divorced before 2019.
Dividing the property can be a contentious process. You probably considered your finances as a single unit before the divorce. In reality, all your possessions are either marital property or individual property. By default, most property acquired during the marriage is marital property: both of your earnings, houses purchased together (even if only one name is on the title), and retirement funds. However, a few types of property are generally considered individual:
- Property either spouse owned before the marriage and kept separate
- Gifts or bequests one of you has received during the marriage
- A payment for pain and suffering from a personal injury lawsuit
Individual property becomes marital property if the individual mixes it with marital property. For instance, if you deposit a gift into a shared bank account, it now belongs to both of you.
In a few states, called Community Property states, all marital assets are considered equally owned and are generally split 50/50. In the others, called Equitable Distribution states, the court divides assets based on each spouse’s financial situation, including the needs of the children. It’s impossible to predict how this division will shake out.
Transfers of property as part of a divorce settlement usually are not liable to gift or estate tax. But these transfers must be part of the divorce decree or agreed upon within three years after.
If assets have to be sold or accessed to divide them, tax may be assessed. For instance, if the couple sells their marital home in order to divide the proceeds, they may have to pay capital gains tax. If they have lived in the home at least two of the last five years, they can take an exclusion of $500,000. However, if the house costs more than that, the excess will be taxed as capital gains.
So, if you are selling a primary residence for a small profit, you won’t need to worry about taxes. But if you are selling a vacation home or other property not the primary residence, or if your profit on the home is over $500,000, you may need to pay capital gains tax. If you wait till after the divorce and one of you sells the home alone, the exclusion is only $250,000.
The divorce agreement will also divide your retirement accounts. Qualified plans, such as 401(k)s, can be transferred using a Qualified Domestic Relations Order. That allows the receiving spouse to transfer the plan into a new qualified plan or roll it over into an IRA without penalty or taxation. If you need to divide an IRA, that is called a transfer incident to divorce. It’s important that all such transfers are properly labeled as such to avoid a tax penalty. The last thing you want is to take the money out and need to pay tax on the whole thing!
Once all accounts are transferred, each spouse should update their beneficiaries accordingly. Unless the divorce agreement requires it, you probably do not want your ex-spouse still listed as a beneficiary.
Learn More About How Divorce Will Affect Your Finances
A divorce has a massive impact on the finances of both spouses. Only by thoroughly understanding your current financial picture and future needs can you plan appropriately. Whether you’re contemplating divorce or in the process of negotiating one, you should speak to a financial advisor. For a quick primer of the important issues, watch our webinar on May 12, at noon Central Time. We’ll learn about child support, spousal support, dividing assets, taxes, and more. Bring all your questions!