Why a 50/50 Divorce Settlement Might Not Be Fair

There are many issues to negotiate during a divorce, chief among which is the financial settlement. Each party will have ideas about what they want or need going forward. And sometimes there are emotional reasons that someone may want “more” of the marital assets. For many couples, however, just adding up all of the assets and then dividing them in half may seem like the easiest and most fair way to move forward. But there are a number of tax considerations to take into account and often divorce attorneys and mediators are not fully aware of all of the considerations and may inadvertently negotiate a settlement that looks fair on paper but leaves one of the parties at a significant disadvantage. The examples below will illustrate how easily something that seems fair from the surface can actually be quite unfair if you do not understand future tax considerations.

Account Types Matter During Divorce

One key consideration is the type of asset that is being divided. Let’s take the example of Laura and Steve, both in their early 50s. They have four investment accounts:

Account Owner Current Value
401k
Steve
$100,000
Rollover IRA
Steve
$100,000
Inherited IRA
Laura
$100,000
Brokerage
Joint
$100,000

From the surface, it might look easiest to let Steve keep his two retirement accounts and give Laura the joint account and her inherited IRA. Both would end up with $200,000 and it seems “fair”. However, let’s say three months after the divorce each person needs $10,000 for an unanticipated emergency. Laura can freely take that money out of the joint brokerage account and only pay taxes (at the more favorable capital gains rate) on the portion of the withdrawal that is growth from investing. Steve, on the other hand, will have no choice but to make the withdrawal from a retirement account and because he is not yet 59 1/2, not only will he be taxed on the entire amount of the withdrawal (at the higher ordinary income rate) but he will also have to pay a 10% penalty. By not understanding the rules for the various account types, what looked like a fair settlement actually put Steve at a disadvantage.

Considering the Cost Basis of Investments in Your Settlement

Another potential consideration is the cost basis of any securities owned. For this case, let’s consider the example of Ted and Jane. Jane has worked for years in the tech industry and has always received company stock as part of her compensation. Her most recent company, XYZ Technologies, has grown rapidly, as has the value of the stock she has received. She and Ted have a joint brokerage account where they hold this stock, along with other stocks they have purchased over time.

Stock Original Cost Current Value Gain
XYZ
$15,000
$500,000
$485,000
ABC
$215,000
$250,000
$35,000
PQR
$225,000
$250,000
$25,000

Just looking at the current value of the stocks, it seems like the easy answer is to let Jane keep the XYZ stock she earned at work and give Ted the ABC and PQR stocks. Each person ends up with $500,000 and it seems “fair”. Here again, though, you have to understand the future tax consequences of this settlement. Capital gains tax will be owed on the gain in value when the stocks are eventually sold. So, if both were to sell at this point, Jane would owe tax on $485,000, while Ted would only owe tax on $60,000. Another case where not understanding how taxes work can leave one person in a much worse situation.

Selling (or Not) the House as Part of Your Divorce Settlement

In addition to various investment accounts, it’s also important to understand the tax considerations related to what is likely a couple’s most valuable investment – their home. In this example, we will use the case of Janet and Doug. They have been married for almost 30 years and bought their home 25 years ago. They originally paid $100,000 for the house and it is now worth $600,000, so they have a $500,000 capital gain. Under current tax rules, each person is entitled to exclude $250,000 in capital gains on sale of their primary residence. If Janet and Doug sell their house prior to divorcing, they can each apply their exclusion and they would not owe any capital gains tax on the $500,000 appreciation in their home. But let’s say the couple agreed that Janet would stay in the house for a short period and she gave Doug other assets equal to his share of the home during the divorce. Now, a year after the divorce is final, Janet decides to sell the home, still for $600,000. At this point, she is still able to exclude $250,000 in capital gains but can no longer apply Doug’s exclusion so she will owe tax on the other $250,000 of the gain. She may have been much better off selling the home while she was still married to Doug and then dividing the proceeds along with their other assets.

With the examples above, you can see how easy it is to agree to something that seems “fair” to everyone but leaves one person with a tax bomb down the road. When negotiating your divorce settlement, it is important to be on the lookout for these issues (among others) or engage a professional to help you avoid potentially costly mistakes.