Some of the choices that people make during divorce can have major tax implications. For example, the decision to liquidate or sell off certain resources might theoretically result in a need to pay capital gains taxes. The financial moves that spouses perform to divide their property can potentially lead to a variety of different tax responsibilities that can amplify the financial impact of an upcoming divorce.
Those preparing for divorce proceedings and property division negotiations need to familiarize themselves with the potential tax issues that may arise because of the financial moves made during a divorce.
Frequently, spouses with high-value marital estates have to address retirement accounts as part of the divorce process. The right paperwork can help minimize the income tax implications of dividing retirement accounts.
Early withdrawals can lead to taxes
There are many financial benefits to setting resources aside in tax-deferred retirement accounts like off Roth IRAs and 401(k)s. Not only can professionals preserve resources for later in life, but they can reduce their taxable income for the year while doing so.
The contributions made to a retirement account helped reduce the taxable income of an individual for the year. On the other hand, withdrawals from retirement accounts add to an individual’s income and can significantly increase their income tax obligations.
Mistakes when dividing retirement accounts as part of a divorce can potentially trigger major income tax consequences. If the spouses fail to follow the right procedure to divide the account, the account holder may face a significant increase in taxable income and more income tax obligations than they should otherwise.
The right procedure makes all the difference
If someone with a retirement savings account needs to divide it as part of a divorce, they can potentially do so without suffering an income tax increase for the year. Having a lawyer draft a qualified domestic relations order (QDRO) based on the final property division decree allows for the division of one account into two separate accounts.
Doing so is not the same as making an early withdrawal from the account. The account holder can avoid the need to claim the amount withdrawn as income because it remains in a retirement account for the use of the other spouse. They can also avoid the 10% penalty typically assessed on any early withdrawal.
Spouses who understand the different financial moves that can have tax consequences can minimize the tax implications of divorce. Drafting a QDRO and submitting it to the person managing retirement resources can be of the utmost importance for those with complex marital estates who are preparing for divorce.