Divorce and Taxes: How to Avoid Costly Mistakes

The Wall Street Journal in an article entitled Divorce: Counting Money Gets Tougher, highlights the common mistakes made by unwary litigants. These mistakes can have dire tax consequences.

Some common blunders: Dividing a stock portfolio down the middle without checking for losses or gains -- which can trigger either a tax break or a big capital-gains tax hit.

There are steps you can take to avoid house-related tax hits. If you keep the house and retitle it in your name, but end up selling it after the split, you may be able to shield only as much as $250,000 of the gains from capital-gains taxes. Consider selling the house while you're still married, or include specific provisions for the sale of the house in the divorce decree, to shield as much as $500,000 from capital-gains taxes.

The QDRO -- short for Qualified Domestic Relations Order -- is a court order that spells out who gets what in an employer-sponsored retirement plan such as a pension or a 401(k). QDROs must be approved by both the employer's retirement-plan administrator and the divorce-court judge.

The document lets you make transfers to an Individual Retirement Account, or make early fund withdrawals from the plan without paying the usual 10% IRS penalty if you're under age 59½. (You'll still have to pay income taxes on withdrawals.)

Try to complete the QDRO before the divorce is finalized. Otherwise, if your ex should die, remarry or leave the company, it may be tough to receive any retirement money.

Adding to the confusion, IRAs don't require QDROs. If you write it in your divorce agreement, you can split an IRA by transferring the funds directly into other IRAs without being subject to penalties or taxes.

If you're paying alimony, you can claim the payments as a deduction. But if you receive alimony payments, they count as taxable income. Child-support payments are neither deductible nor taxable.

Other tips: Take out a term life-insurance policy on the alimony-paying spouse. And update wills, trusts and beneficiary designations on retirement plans and insurance policies, so that your ex doesn't end up inheriting an unintended windfall.

An easy way to avoid making bad financial decisions incident to the divorce is to consult with a certified divorce financial planner. I have found, in some cases, a certified divorce financial planners assistance to be invaluable.

After analyzing the client’s finances, cash flow, work and income history, this professional can run “what-if" and tax impacted scenarios on settlement proposals. In this way, a settlement can be specifically structured to the client’s present and future after tax financial needs.

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