Lump sum payments in a divorce settlement are somewhat common, whether made to satisfy an award of alimony or when dividing certain types of property. Generally, lump sum transfers between former spouses made pursuant to a divorce decree are not taxable. However, depending on the type of asset transferred, there may be requirements or conditions that must be met to avoid taxation.
Alimony
Most people think of alimony as a periodic payment but it can also be made as a lump sum payment. The parties first calculate how much alimony would be paid for the entire term awarded in the divorce decree (i.e. multiply $X per month for X years). This amount is then discounted for present value because it is being paid out in advance instead of over time. The recipient receives less money than they would have received at the end of the term if they were paid over time but gets the cash upfront to use or invest in any way.
Neither periodic nor lump sum alimony paid pursuant to a divorce decree are taxable events. The amount paid is not deductible by the payor and is not included as income for the payee.
Bank Accounts
Any transfers to divide bank accounts as part of the divorce settlement are not taxable.
IRA Accounts
IRAs can be divided in divorce tax-free by doing an IRA-to-IRA transfer.
401K and Pension Accounts
These types of accounts require the use of a Qualified Domestic Relations Order (commonly referred to as a “QDRO”) to divide the accounts without triggering taxes. An attorney would work with the 401K or pension plan administrator to effectuate the transfer. The QDRO must be approved by the Court.
Publicly Traded Stock
Stock in a brokerage can be divided in a divorce without being taxed. Typically they are divided on an “in kind” basis, meaning the parties are on equal footing for tax purposes if and when they decide to sell the stock.
Buyout of the Marital Home
In a buyout, the spouse being bought out either gets a lump sum payment in exchange for their share of the house or assets that are the equivalent of that amount. The spouse selling their interest gives the purchasing spouse a quit claim deed which is then recorded in the land record. This transaction is not taxable when done as part of the divorce settlement.
Sale of the Marital Home
Both parties can agree to sell the house to a third party but that could result in capital gains taxes. Under tax laws, a married couple can exclude up to $500,000 of capital gains if they used the house as their primary residence for 2 of the last 5 years and they file a joint income tax return. However, if the couple is no longer married when they sell the house and file separate income tax returns, the spouse that was awarded the house can only exclude $250,000 of capital gains. Accordingly, the parties should discuss whether it makes sense to sell the house before the divorce is finalized to maximize the exclusion.
If you are considering divorce, hiring an experienced attorney will help ensure that tax laws are taken into account when negotiating issues like support and property distribution. Our lawyers have extensive experience serving high earners and high net worth individuals in divorce. Contact us for a consultation to learn how we can assist you with your divorce.
