When negotiating a divorce settlement agreement, it’s natural to focus on the current value of assets. However, assets that appear equal on paper are often worth very different amounts after taxes and withdrawal rules are considered.
Understanding these differences can help you avoid costly mistakes and make more informed decisions during the divorce process. Below are three important financial considerations that are often overlooked when dividing assets in a divorce.
1. Pre-Tax vs. After-Tax Assets
Not all $100,000 accounts are created equal.
Assets held in an Individual Retirement Account (IRA) or other pre-tax retirement account are generally taxable when money is withdrawn. By contrast, money withdrawn from a taxable brokerage account is not automatically treated as income. While there may be capital gains taxes associated with selling investments, those taxes are often lower than ordinary income tax rates.
Example
Sally agrees to let Sam keep his $100,000 brokerage account so that she can keep her $100,000 IRA.
After the divorce, Sally withdraws $5,000 from her IRA to cover expenses. That withdrawal is added to her taxable income for the year and may also be subject to penalties if she is under age 59½. Assuming she is in the 22% federal tax bracket, she would net only about $3,900 after federal taxes, before considering state taxes and any penalties.
Meanwhile, if Sam needs $5,000 from his brokerage account, he can generally access the funds without an early withdrawal penalty. Depending on the investments and cost basis, there may be little or no tax impact.
While both accounts were worth $100,000 on paper, the after-tax value available to each spouse may be very different.
2. Cost Basis Matters
Even when two brokerage accounts have the same market value, they may not have the same after-tax value.
Cost basis is generally the amount paid for an investment, adjusted for certain transactions over time. When an investment is sold, taxes are typically owed on the gain above the cost basis. The lower the cost basis, the larger the potential tax bill.
Example
Sam owns $100,000 of Apple stock with a cost basis of $25,000.
Sally owns $100,000 of Apple stock with a cost basis of $50,000.
Assuming they are in the same tax bracket, Sam’s stock position carries a much larger embedded tax liability. If both sell their holdings, Sam would recognize $75,000 of capital gains, while Sally would recognize only $50,000.
As a result, two accounts with identical market values may have significantly different after-tax values.
When evaluating a proposed divorce settlement, reviewing cost basis information can be just as important as reviewing account balances.
3. Tax Laws Can Create Unequal Outcomes
Tax rules can dramatically affect the value of assets received in a divorce.
Consider a couple who owns both a primary residence and a vacation home. Neither property has a mortgage, and each would generate a $200,000 capital gain if sold.
At first glance, assigning one property to each spouse may appear to be an equal division. However, tax laws may create a very different outcome.
Under current IRS rules, homeowners may generally exclude up to $250,000 of capital gains from the sale of a primary residence if they have lived in the home for at least two of the previous five years. Married couples filing jointly may qualify for an exclusion of up to $500,000.
If one spouse receives the primary residence and sells it soon after the divorce, they may owe no capital gains tax. The spouse who receives the vacation home could owe tax on the full $200,000 gain.
For couples whose primary residence has appreciated significantly, it may be worth discussing the timing of a potential sale before the divorce is finalized. In some situations, the larger exclusion available to married couples may result in substantial tax savings.
For more information, see IRS Topic No. 701, Sale of Your Home.
The Bottom Line
Divorce settlements involve far more than simply dividing assets equally. Taxes, cost basis, withdrawal rules, and future financial implications can all affect the true value of what each spouse receives.
Before finalizing a divorce agreement, consider working with qualified professionals who can help evaluate the financial impact of various settlement options. A financial advisor and Certified Divorce Financial Analyst® (CDFA®) can help identify opportunities and potential pitfalls that might otherwise be overlooked.
The goal is not simply to divide assets equally on paper, but to help ensure the settlement is fair and financially sound in the years ahead.
