Divorce and related taxes are actually simple.
Now, this may be an unexpected opening to a lengthy column in a professional journal. Here is the explanation: "Simple" is not the same as "easy." Divorce and taxes are in fact simple — as long as you do everything right. And that second part is not easy. This author has seen divorcing couples make mistakes that have cost them thousands of dollars in taxes, usually because they thought they knew what they were doing. Others have paid the price for missing a small bit of instructions or a detail that seemed irrelevant to them at the time.
CPAs are in a unique position to add value by guiding clients around potential pitfalls on the tax side of life. Unfortunately, divorce is a reality that some clients will have to face. This column should serve as a helpful blueprint for avoiding expensive mistakes.Trap No. 1: Creative treatment of the QDRO for qualified defined benefit plan accounts
It would be helpful to first review the definitions of a few key terms.
A qualified domestic relations order (QDRO) is a vehicle for transferring certain retirement funds from one spouse to another in a divorce. Think of it as a court order that directs and authorizes the plan administrator of a qualified retirement plan to present to the alternate payee the dollar amount or the percentage of a participant's qualified retirement plan account balance.
It is important to remember that, in theory, the alternate payee's funds could remain in a separate account inside the plan for which the QDRO was written. The payee could then take distributions in the future without incurring any taxable income or penalty. The author has yet to encounter a qualified retirement plan administrator that allows an alternate payee to have such an account in the plan. The author usually recommends that spouses execute the QDRO and move the funds to another retirement savings account established for the alternate payee.
Consider the following key points about QDROs:
- Before any funds are released to the alternate payee, the plan administrator must have approved the court-ordered QDRO. Most divorcing couples assume that the funds will become available as soon as they sign the divorce agreement — this is not the case. If the money is directed into a tax-deferred retirement savings account, the delay is not a problem. However, if a client has immediate plans for those funds (such as covering living expenses while searching for a job), he or she needs a bridge to work with the timing of the plan sponsor's QDRO approval process.
- QDROs can only be used to divide qualified retirement accounts governed by ERISA such as 401(k) and 403(b) accounts, but not IRAs. While a QDRO may be used to divide defined benefit plans, the procedure explained here applies only to plans that allow a lump-sum distribution such as a defined contribution account.
- Military retirement plans do not use QDROs and, as such, are not covered here.
When executed carefully, QDROs work exactly as intended and keep the transfer of assets a nontaxable transaction. A QDRO is drafted, approved by the court, signed by the judge, and approved by the plan administrator. The funds that have been awarded to the nonparticipant spouse (the alternate payee) are transferred into a tax-deferred retirement account, such as an IRA, set up by the alternate payee in accordance with the terms of the QDRO. As long as the funds in question move out of a qualified account and directly into the alternate payee's retirement account, no income taxes or early withdrawal penalties are due on the transfer.
The situation gets complicated when the alternate payee wants to use some of the money immediately.
Example 1: A and B are going through a divorce. A has $600,000 in his 401(k) account that will be split 50/50. B has big plans for her $300,000 portion of that transfer. B's attorney mentioned something about a QDRO needed to split her husband's 401(k) account and about putting that money into a tax-deferred retirement account, but it all sounded technical and boring. B wants to celebrate her new single life instead. She wants to purchase a brand-new luxury car for $40,000 and deposit the rest of the money into her retirement account. B calls her CPA to find out whether she will be liable for any extra income tax when she files her return next April.
Because B's withdrawal to purchase the car breaches the "safety corridor" between qualified retirement accounts, the withdrawal amount is subject to income tax.
The silver lining is that, if the withdrawal is executed pursuant to a QDRO, the 10% additional tax for early distributions does not apply (see Sec. 72(t)(2)(C)). Once the alternate payee directly transfers funds into an IRA or other tax-deferred retirement account, he or she loses the opportunity to withdraw those same funds without paying the additional tax. So, if B had first placed the QDRO money into her IRA and then decided that she wanted to withdraw some amount to pay for the car, she would no longer qualify for the exception from the additional tax under Sec. 72(t)(2)(C). Therefore, her post-QDRO IRA account withdrawal would be subject to the 10% additional tax.
Meanwhile, B has done her internet research and learned that the retirement plan administrator will withhold income taxes in the amount of 20% of the balance that is not transferred directly to her IRA. If B asks the plan administrator to withdraw the $40,000 to pay for the car, 20% of that ($8,000) will go to the IRS, and she will only receive $32,000.
B calculates that she must request $50,000 in cash so that after the required 20% is withheld ($10,000), she will get her $40,000. B will miss out on spending $10,000, but that money goes straight to the IRS anyway. No tax bill, keys in hand, wind in her hair. Is this a win-win forB?
Not exactly. B must report the extra $50,000 she took in cash as taxable income. In some cases, that may be enough to bump her into a higher tax bracket. If that happens, her overall taxes for the year will be higher than she anticipated due to the higher marginal tax rate.
If a CPA is facing this client scenario and has a client like B who is determined to buy a new car, the CPA can minimize the damage by suggesting a withdrawal amount that at least keeps her from moving into a higher tax bracket.
CPAs should consider the following key takeaways from this scenario:
- CPAs should caution clients against using QDRO retirement account balance transfers for anything other than boosting another retirement account. Everyone's situation is different, and sometimes this may not be possible. However, in most cases a straightforward "QDRO to retirement account" transfer is the best choice for long-term financial security.
- If an alternate payee's portion of the account transfer made under a QDRO must be taken in cash because of personal financial circumstances, the CPA can help the client calculate the full cost of the decision. This means including not only the automatic 20% tax withholding but also the cost of a potential bump up in tax bracket, along with any state and local income taxes that may be due on the withdrawal.
- CPAs should educate clients on the requirements of Sec. 72(t)(2)(C) and the importance of timing the withdrawals in a way that protects them from incurring the 10% additional tax. In general, if a portion of the retirement account payout must be taken in cash, it is best to do that before the money goes into the alternate payee's new tax-deferred retirement account.
Example 2: C and D are in the final stages of negotiating their divorce. C, who owns a network of used car dealerships, offers to split his personal investment account 50/50 with D. D is pleased with her share of the investment account. Looking at the market value of the investments at the time of the offer, all seems reasonable and fair.
What can possibly go wrong? Unbeknownst to D, C has picked investments with unrealized losses for his own portfolio and passed the ones with unrealized gains on to his soon-to-be ex-wife. D was not interested in the details of investments and did not make the time to consult with a tax specialist before signing the paperwork.
After the divorce is finalized, D reviews the portfolio allocations and decides that she is not comfortable with the risk level of the investments she was awarded. The fact that she is still angry with C does not help the situation. In fact, D even hires a new investment adviser so she can have a fresh start that is free of anything C has ever touched. She asks her new investment adviser to sell those old investments and get her into a more conservative portfolio.
That is where the problem gets worse. In the reallocation, D converts unrealized gains into realized gains, which may be short-term (one year or less) or long-term (more than one year). She must now report those capital gains on her tax return. The additional taxes effectively lower the share of assets D received in the divorce settlement.
This highlights the importance of monitoring unrealized gains and losses, as well as understanding the tax consequences of dividing different types of accounts. If our couple aim for a 50/50 division of their savings and investment accounts, with C taking a $100,000 bank savings account while D gets a $100,000 investment account with $30,000 in unrealized gains, the spouses do not get a 50/50 division post-tax, no matter how good the deal may look on paper.
CPAs should consider the following key takeaways from this scenario:
- When a client mentions that he or she is facing a divorce, offer to help him or her with tax issues. A CPA can add a lot of value by reviewing the property settlement agreement before it is executed.
- A CPA should use the conversation as an opportunity to educate the client. When it comes to divorce, not all dollars are created equal. Asset types matter tremendously, and small details can skew a distribution that looks fair based on the numbers alone.
Example 3: E and F are in their mid-40s. Married for 15 years, they have been good tax clients for a long time. They tell the CPA about their divorce as they drop off their tax paperwork in her office in late January. Both are adamant that they want to keep the CPA as their tax preparer after the divorce. They promise that they will keep personal drama out of the professional relationship. F gets emotional and cries, while E says that he cannot imagine finding another tax preparer he can trust. Now what?
This final "tax trap" is not related to the clients' tax expense but rather to the management of the CPA's tax practice. Anyone in this position would be understandably flattered and honored by the clients' loyalty, but the CPA must consider several issues besides handing F a box of tissues.
First, the moment a couple for whom a CPA has previously prepared a joint tax return announce an intention to divorce, their individual interests are often placed at odds with each other. This is common for a "traditional" divorce process that is notoriously contentious, and it can also happen during collaborative divorces despite well-intentioned spouses and a qualified support team. Even if E and F are adamant that they will leave the CPA out of the drama, some spillover from the divorce is virtually guaranteed to land on the CPA. The CPA must look ahead and consider the potential downside before deciding whether to retain both soon-to-be ex-spouses as clients.
The downside is not limited to witnessing emotional outbursts or being put in the middle of an argument. While preparing tax returns for both sides of a divorce case is not expressly prohibited by the IRS rules or the AICPA Code of Professional Conduct (unless, of course, this conflict of interest impairs the CPA's objectivity and professional judgment), it can expose a CPA to liability. If the spouses choose to remain clients of the CPA's practice and the CPA considers keeping them both as clients, the CPA needs to weigh the possibility of a potential conflict of interest and how this may impact the CPA's objectivity and professional judgment going forward.
If the CPA finds that there may be a conflict, he or she may opt to withdraw from providing the service. The timing of withdrawal matters: Ideally, the CPA wants to complete the service he or she has been engaged to perform, especially if withdrawing before completing the work can put either spouse at a disadvantage in the divorce process.
Alternatively, if the CPA believes he or she can provide objective advice to both spouses, both clients should be asked to sign consent forms stating that they have been fully informed and choose to waive any potential conflict of interest. This is a situation that warrants a conversation with the CPA's attorney, ideally someone who understands the intricacies of a CPA's professional responsibilities to clients. Be sure to ask about the limitations of the "conflict of interest" disclosure, including the possibility that the client later argues his consent had not been "informed." Involvement in a dispute between clients is on the list of the top five reasons small to midsize CPA firms get sued, according to CAMICO, a professional liability insurance provider. So, even if F and E are vocal in expressing their willingness to "make it work," the CPA may want to tread carefully.
CPAs should consider the following key takeaways from this scenario:
- If a divorcing couple both wish to remain clients of the same CPA, the CPA should express gratitude for their loyalty and ask for a timeout to consider the decision.
- The CPA should consult an attorney to review the risks and obligations that pertain to the situation. The CPA should not attempt to dabble in legal advice, as that can lead to disastrous and expensive consequences.
- The CPA must consider both IRS rules and the AICPA Code of Professional Conduct on this matter, as they are not identical (for more, see Horwitz, "Tax Practice Responsibilities: Conflicts of Interest: IRS Rules Differ From AICPA Professional Standards," 42 The Tax Adviser 776 (November 2011). If a CPA needs help weighing the ethics of this decision, the AICPA Ethics Hotline at email@example.com and 888-777-7077 is an additional resource.
When it comes to clients going through a divorce, communication is critical. A CPA should encourage clients to share their thoughts and possible property division scenarios, ask them specifically about known problem spots, and offer to be in the room when certain details of the agreement are discussed.
Even an amicable divorce can be extremely stressful, so the CPA cannot expect clients to remember to bring up questions. The CPA, as a trusted adviser, must be proactive for them.
|Tracy Stewart is the owner of Tracy Stewart CPA PLLC in College Station, Texas. Her practice focuses on the financial issues of divorce. Theodore Sarenski is president and CEO of Blue Ocean Strategic Capital LLC in Syracuse, N.Y. Mr. Sarenski is chairman of the AICPA Advanced Personal Financial Planning Conference. He is also a past chairman of the AICPA Personal Financial Planning Executive Committee and a former member of the Tax Literacy Commission. For more information about this column, contact firstname.lastname@example.org.