How Divorce Affects My Investments

The division of marital property during divorce can be complex, and the division of investments is no exception. But once it is determined what percentage of distribution between the parties is equitable (whether by the parties’ agreement or by a judge’s order), the division of these accounts can be quite simple. But if one party elects to keep an investment account in exchange for other property, capital gains taxes can make things more complicated.

Is the Investment Marital Property?

The first consideration is whether the investment is marital property.  This depends on whether the investment was purchased with marital funds, which is generally money that was earned during the course of the marriage. Therefore, if a spouse had an investment account before they were married, then that account is his/her separate property.  The increase in the value of separate property during the marriage is also considered separate property unless that increase is caused by the contributions or efforts of the other spouse. This contribution could be active management of the investment, or support as a homemaker while the spouse who owns the separate property actively manages the investment. Generally, if a separate investment increases in value during the marriage due to the active management of either spouse, the increase in value is marital property that is subject to equitable distribution.

Non-Retirement Investment Accounts

Like any other asset in a divorce, investment accounts that are marital property are distributed equitably between the parties.  In most cases, investment accounts are split evenly in equitable distribution. One way to divide marital investment assets is to distribute shares in the account evenly without liquidating the account; this is commonly referred to as “in kind.” This is a clean and simple way to divide an investment account. 

Another way to deal with investment accounts in equitable distribution is for one spouse to keep the entire investment account in exchange for other assets.  For example, if the account is worth $50,000, one spouse could keep the account and give the other spouse $25,000 worth of other assets.  In this scenario, the parties avoid the hassle of transferring shares into another investment account, but must consider the capital gains taxes that are incurred when the account is sold.  Both spouses are responsible for the capital gains taxes from the sale of marital assets.  Therefore, if the account is sold after the divorce has been finalized, the ex-spouse can still be liable for half of the capital gains taxes on the portion of the investment that was marital property.  This liability may depend upon how the parties file their taxes and whose social security number the account is under.  To avoid these complications, the parties should address the issue of capital gains in their settlement agreements.

Retirement Accounts

Retirement accounts are distributed in divorce just like any other investment account.  If the retirement account is an IRA, many companies will allow you to divide the account, in accordance with the provisions of a judgment of divorce.  However, some IRAs and all 401(k)s and pensions require that the parties obtain a qualified domestic relations order (“QDRO”) from a court before they can distribute funds from the account. 

Once the QDRO is signed by the court, the alternate payee has a few options to choose from.  One option is to rollover the funds into his/her own retirement account.  This approach does not incur any immediate penalties or taxes.  Another option is for the alternate payee to receive a direct distribution with no penalty, but a 20% Federal Withholding Tax.  This option is available to spouses of all ages and is perfect for spouses in immediate need of cash.

To avoid these considerations, a payor spouse may elect to retain his/her retirement account and credit the value by exchanging other assets.  This approach requires that the parties consider the income taxes that will be incurred when the retirement account is paid out.  Accordingly, the value of the retirement account will be worth less in the exchange because it is tax affected.

Conclusion

In considering options for investments during a divorce and drafting the provisions of a settlement agreement, both parties must consider tax effects associated with retirement and non-retirement investment accounts.