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Splitting Investment Accounts During Divorce: Tips to Avoid Tax Penalties

March 21, 2024 Uncategorized

Splitting Investment Accounts During Divorce: Tips to Avoid Tax Penalties

Going through a divorce can be really tough, especially when it comes to figuring out how to split up your investments and retirement accounts. It’s important to understand how to divide them properly so you don’t end up paying unnecessary taxes or penalties.

In this article, we’ll walk through some key things to keep in mind when splitting investment accounts during divorce. We’ll also give tips on how to avoid tax penalties and make the process smoother.

Update Your Beneficiaries

One of the first things you’ll want to do when starting the divorce process is update the beneficiaries on all your investment and retirement accounts. It’s common for spouses to be listed as the primary beneficiary on 401(k)s, IRAs, life insurance policies, etc. But once divorce proceedings begin, you’ll probably want to change that.

Not updating beneficiaries can lead to your ex getting assets that were intended for other people (like kids). So make sure to file new beneficiary forms as soon as possible – don’t wait until the divorce is finalized.[1]

Understand How Different Accounts Are Handled

It’s important to understand how each type of account is treated legally and tax-wise when dividing them up.[2] This will impact the options available to split them.

Taxable Investment Accounts

For taxable investment accounts like brokerage accounts, the process is fairly straightforward. You can choose to either:

  • Sell the assets and split the proceeds
  • Split the actual investment holdings (e.g. 50/50 split of shares)

Selling investments can trigger capital gains taxes. But if you split the holdings directly, both parties maintain the original cost basis. This avoids an immediate tax hit.[2]

Retirement Accounts

Dividing up retirement accounts like 401(k)s and IRAs is more complicated due to tax and penalty implications. There are a few options:

  • Transfer assets to the other spouse’s IRA via direct rollover. No taxes/penalties.
  • Withdraw funds and split. Triggers taxes and maybe early withdrawal penalty.
  • Keep accounts separate but rebalance holdings. Maintains tax benefits.

Rolling over retirement funds directly to your ex-spouse’s IRA avoids any penalties or extra taxes. Withdrawing funds should be a last resort since it can trigger income taxes and a 10% early withdrawal fee if you’re under age 59.5.[3]

Understand Community Property Laws

If you live in a community property state like California, Texas, or Washington, retirement accounts and some investments may automatically be considered joint marital property. This means they get split 50/50 regardless of whose name is on the account.[4]

It’s important to understand how your state’s laws handle property division so you know what to expect. Your lawyer can provide guidance here.

Create a QDRO for Retirement Accounts

To split up retirement accounts like 401(k)s and pensions without paying taxes/penalties, you need a qualified domestic relations order (QDRO). This is a special court order that tells the plan administrator how to divide the account.[4]

Make sure the QDRO specifies:

  • The amount or percentage each spouse gets
  • Who pays any transaction fees
  • How to handle investment gains/losses after separation

Without a QDRO, dividing retirement accounts can trigger taxes and penalties. So work with your lawyers to get this handled properly.

Consider the Tax Implications

It’s important to think about the tax consequences of any asset division, especially when dealing with retirement accounts. Here are some key things to consider:

  • Withdrawing retirement funds directly can lead to income taxes and early withdrawal penalties
  • Rolling funds over to an IRA avoids taxes and penalties
  • Splitting up tax-deferred accounts reduces future tax benefits
  • Selling investments can trigger capital gains taxes

Work closely with your financial advisor and accountant to understand the tax implications before finalizing any division of assets.[5]

Don’t Forget About Spousal Support

In addition to dividing assets, you may have to pay or receive spousal support (alimony). This can impact how investment and retirement accounts are split up.

For example, if you’ll be paying high alimony, you may want more of the retirement savings. Or if you’ll be receiving spousal support, you may need less of the investment assets.

Look at alimony and child support holistically when making financial decisions during a divorce.

Hire a Divorce Financial Analyst

Working with a divorce financial analyst can help you understand all the options for dividing accounts and avoid costly mistakes.

A financial analyst who specializes in divorce can:[6]

  • Review all investment/retirement accounts and how they could be split
  • Calculate the tax impact of different division scenarios
  • Suggest alternatives to avoid penalties
  • Help draft QDROs

Getting professional advice can give you peace of mind that your accounts are being properly divided.

Take Your Time Making Decisions

It’s understandable to want to rush through divorce proceedings. However, don’t let that cause you to make hasty decisions about dividing accounts.

Splitting investments and retirement accounts has long-term financial implications. So take your time evaluating the options, even if it delays finalizing the divorce.

Getting it right is worth far more than a quick settlement.

Think Long Term

It’s hard not to make emotional decisions when going through a divorce. But try to set emotions aside when dividing accounts and take a long-term perspective.

Consider your future financial needs, not just immediate desires. This will help you make smarter choices about how to split things up.

For example, you may really want the vacation home now. But you also need to have enough retirement savings in the future. Try to find a balance.

Understand All Your Options

Start by collecting information on all investment and retirement accounts – account numbers, statements, terms, etc. Then learn about the different options for dividing them based on the account type.

An attorney or financial analyst can explain the pros and cons of each option. Go into the process with eyes wide open about the possibilities.

Communicate with Your Ex

Splitting up finances with your spouse can be really emotionally charged. But good communication can help ease the process.

Sit down together and openly discuss both of your needs, priorities and concerns. Finding common ground will help you compromise.

Even if you can’t see eye-to-eye on everything, keeping the lines of communication open helps.

Don’t Forget About Taxes!

It’s easy to overlook the tax impact when dividing up investment and retirement accounts. But this can be a costly mistake.

Be sure to understand how taxes apply for 401(k) rollovers, withdrawing retirement funds, selling investments, etc. Getting hit with penalties can ruin an otherwise equitable split.

Review All the Paperwork

Before finalizing your divorce settlement, carefully review any paperwork related to dividing your investment and retirement accounts.

Make sure the details match your understanding of the agreement – account numbers, division percentages, beneficiaries etc. Ask questions if anything is unclear or different from what you recalled agreeing to.

Get it In Writing

Any verbal agreements about dividing accounts should be formally put in writing before finalizing the divorce. This ensures there are no misunderstandings later.

Have your lawyers draft up a written agreement outlining exactly how each investment and retirement account will be divided. Get this added to the final divorce decree.

Roll Over Retirement Funds ASAP

Once the divorce is finalized, roll over any retirement funds being transferred to your ex-spouse right away. This avoids the accounts staying in your name longer than needed.

Make rolling over assets a priority. The sooner it’s done, the sooner you close the book on jointly owned accounts.

Review Your New Financial Situation

After dividing up accounts, take time to review your new financial situation thoroughly. Evaluate things like:

  • Asset allocation across your investment accounts
  • Retirement savings and if you’re still on track
  • Estate plan and if beneficiary designations need updating
  • Income and expenses to ensure you’re living within your means

Make any necessary adjustments to get your finances in good order post-divorce.

Change Passwords and Security Questions

An important security step is to change the passwords and security questions for any financial accounts you’re keeping. This prevents your ex from accessing them later on.

Also update passwords on your email, phone, tax services, etc. Anything financially related that your spouse could have previously accessed.

Consult a Financial Advisor

Sitting down with a financial advisor can help you navigate all the financial changes after a divorce.

An advisor can review your new situation and make recommendations about reallocating assets, adjusting your budget, retirement planning and more.

Getting professional advice provides peace of mind that your finances are back on track.

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