Journey back from divorce can be taxing

Hit from the IRS can make a painful situation worse.

Mar 24, 2013 @ 12:01 am

By Darla Mercado

Just as financial advisers can help couples construct their financial lives around wedded bliss, they can also help them navigate the road to Splitsville should the bliss fade away.

Amid all the squabbling over money, custody arrangements and who gets the silverware, it is easy for couples to lose sight of important tax implications associated with divorce. For many, the tax bite that can come with divorce is even more painful and enduring than the circumstances that led to the divorce.

Just ask Suzanne Meredith, who, eight years ago, found herself embroiled in a messy divorce battle. In an effort to provide more stability for her children — then ages 12 and 16 — she opted to keep the couple's $2 million home.

But when her husband stopped paying spousal support five years later, Ms. Meredith was forced to sell the home and pay a hefty capital gains tax.

“The capital gains taxes weren't necessarily unexpected, but the way I had planned out my finances didn't turn out the way I expected,” said Ms. Meredith, who now rents a small home in Del Mar, Calif.

Ms. Meredith is hardly unique.

SPLIT DECISION

Now that the economy is showing signs of getting back on its feet, more couples are calling it quits. In 2011, 877,000 U.S. couples filed for divorce, up from 872,000 the year before, according to the National Vital Statistics Reports from the Centers for Disease Control and Prevention.

During the recession, the number of divorces actually dropped, presumably due to high legal fees and falling incomes, home values and investments. In 2009, 840,000 couples filed for divorce, down 3.7% from 872,000 in 2006.

Difficult as it may be, divorce is one of those life transitions that often brings new clients into advisers' doors. Stacy Francis, president of Francis Financial Inc., says the majority of new clients she sees are going through a divorce.

“This is an exploding field,” she said. “Divorced clients are becoming a bigger piece of our business.”

That's apparently the case for a number of other advisers as well. Today, 1,577 advisers are certified by the Institute for Divorce Financial Analysts, up nearly 60% from 997 in 2011.

Often, the biggest planning issues around divorce involve taxes.

“Most divorce attorneys aren't experts in estate and tax planning,” said Martin M. Shenkman, a tax attorney at an eponymous firm. “The trauma, antagonism and cost of going through a divorce are so high that at the end of the divorce, the planning that people should do is neglected.”

Consider, for example, the tax distinctions between child support and alimony. Child support is tax- free to the recipient, while alimony is taxable to the recipient and tax-deductible to the payer. Most of the time, recipients aren't thinking of the taxes tied to alimony, advisers say.

A poorly structured alimony deal can wreak havoc on a recipient's financial plan.

Justin A. Reckers, managing director at Pacific Divorce Management LLC, is working with a client whose former husband is an attorney specializing in class actions. The couple originally agreed that the wife would receive 10% of her husband's pay — which fluctuates — as alimony. The husband was paid $56 million for obtaining a lead plaintiff for a case. That meant his wife received $5.6 million in payment — and a tax bill for nearly $2 million.

“This never should have been considered alimony; it should've been an asset transfer,” Mr. Reckers said. Such a transfer would have otherwise been non-taxable, provided it took place within six years after the divorce. Mr. Reckers did not put together this divorce agreement, and he noted the client is now dealing with liens on her investment accounts because of the tax issue.

The division of assets is another source of tax traps, advisers and accountants say. The greatest difficulty is getting clients to understand that not all assets are created equal.

Divorcées, for in-stance, often covet the family home. Many will take it over cash. “On day two, you'll have a house that needs maintenance and that you'll need to pay property taxes on,” said Michael Goodman, president of Wealthstream Advisors Inc. “It's not the best financial decision.”

DIVIDING MONEY

Further, while retirement assets can be divided, the only way to divide money in a qualified plan is to draft a qualified domestic relations order, which will permit the transfer of assets into an IRA without incurring taxes.

The biggest mistake, aside from attempting to split a 401(k) without the QDRO form, is using the newly rolled-over money to fund cash flow needs.

“The wife might put the money into an IRA and take a 10% penalty when she makes withdrawals,” said accountant Tracy B. Stewart. “She can make arrangements so that some of the QDRO money goes into the IRA and the rest goes to her directly to avoid the penalty.”

When it comes to splitting investments held in a brokerage account, divorcing couples don't consider that there could be unrealized gains, and that there could be a capital gains tax bill when the assets are distributed.

This means someone preparing a divorce settlement will need to gross up the amount he or she needs from the liquidation to cover the tax, noted Samantha Fraelich, vice president at Bernard R. Wolfe & Associates Inc.

The story becomes even more complicated when holdings include stocks that may have been inherited or brought over from a different custodian. In that case, the person who owns the stock needs to report the cost basis when it's sold or risk an audit from the IRS, Ms. Fraelich said.

In the best of scenarios, clients going through divorce would work together to investigate the tax consequences of any financial settlement.

“We can work out something much better if we're doing this planning mutually,” said Mr. Shenkman. “What should happen in the course of a divorce, the couple consults an independent tax attorney who can work out the issues relevant to both sides. But I've never seen that happen.”

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