If any amount of alimony specified in the divorce decree is reduced upon the happening of any contingency related to the child, then the amount of the reduction will be treated as child support, rather than alimony, from the start.
The following example shows what many attorneys have incorrectly advised their clients to do.
Example: Kevin and Karen are getting divorced and their son, Josh, is going to live with Karen. Kevin is going to pay Karen $3,000 per month maintenance plus child support. Kevin’s attorney says, “Since Josh is graduating in 5 years, why don’t you pay Karen maintenance of $3,000 a month for 5 years and then reduce it to $2,000 a month for an extra 3 years. Karen won’t have as great a need when Josh leaves home.”
This is creating a serious tax problem for Kevin. The IRS may consider the reduction of $1,000 a month to be child support because it coincides with a child contingency. The IRS will then go after Kevin to collect the taxes he saved by calling it maintenance and they will make it retroactive from the beginning. Five years (60 months) times $1,000 is $72,000 that he will have to pay tax recapture on!
What is a contingency? A contingency relates to a child if it is dependent on an event relating to the child, regardless of whether the event is likely to occur. Some examples are:
- Reaches age 18, 21 or the age of majority in their state
- Gets married
- Graduates from school
- Leaves home
- Joins the military
- Gets a full-time job
Again, if the final divorce order says that alimony reduces or stops upon the event of any of the above contingencies, that will trigger the recapture of taxes.
Monday, February 26, 2007
Saturday, February 17, 2007
Don't get stuck with capital gains taxes
After being involved with over 600 divorce cases, I find that the one question most overlooked by attorneys is, What is the basis in the house (or stocks, other real estate, or other investments in the couple’s portfolio)? Consider the following case study.
Melanie and Mac have been married for 18 years. They have no children. They have decided everything except how to divide the remaining three assets equally. Those assets are a cottage in Hawaii worth $350,000, an IRA worth $150,000 and a savings account worth $250,000. The $250,000 in the savings account represents a loan taken against the cottage in Hawaii.
Mac proposed to Melanie that she take the cottage and sell it. She would net $100,000. And she should also take the IRA worth $150,000. He would take the savings account and they would each end up with $250,000.
Melanie talked this over with her attorney and they thought that this sounded fair. But, we find that the one question most overlooked by attorneys is, “What is the basis?”
What Melanie’s attorney should have asked Mac would have revealed that Mac had paid $90,000 for the cottage 15 years earlier. It was sold at an incredible estate sale. There was a $260,000 capital gain, which created a tax of $52,000 (capital gains tax at 15% plus state tax at 5%).
As this was not their principle residence, they did have to pay the capital gains taxes. There is no exclusion on property that is not the principle residence.
Melanie received $100,000 and had to pay out $52,000, so she had only $48,000 left.
The after-tax value of the IRA is approximately $100,000 (not counting penalties as she is not planning to liquidate it immediately), so Melanie ends up with $148,000. The $250,000 that Mac borrowed from the cabin and put in the savings account was his, tax-free and clear.
He ends up with $250,000 and she ends up with $148,000, because the question was not asked about the basis. Do you think Melanie’s attorney had some liability here? Absolutely!
Be sure to investigate the basis in all assets. Then there will be no surprises.
Melanie and Mac have been married for 18 years. They have no children. They have decided everything except how to divide the remaining three assets equally. Those assets are a cottage in Hawaii worth $350,000, an IRA worth $150,000 and a savings account worth $250,000. The $250,000 in the savings account represents a loan taken against the cottage in Hawaii.
Mac proposed to Melanie that she take the cottage and sell it. She would net $100,000. And she should also take the IRA worth $150,000. He would take the savings account and they would each end up with $250,000.
Melanie talked this over with her attorney and they thought that this sounded fair. But, we find that the one question most overlooked by attorneys is, “What is the basis?”
What Melanie’s attorney should have asked Mac would have revealed that Mac had paid $90,000 for the cottage 15 years earlier. It was sold at an incredible estate sale. There was a $260,000 capital gain, which created a tax of $52,000 (capital gains tax at 15% plus state tax at 5%).
As this was not their principle residence, they did have to pay the capital gains taxes. There is no exclusion on property that is not the principle residence.
Melanie received $100,000 and had to pay out $52,000, so she had only $48,000 left.
The after-tax value of the IRA is approximately $100,000 (not counting penalties as she is not planning to liquidate it immediately), so Melanie ends up with $148,000. The $250,000 that Mac borrowed from the cabin and put in the savings account was his, tax-free and clear.
He ends up with $250,000 and she ends up with $148,000, because the question was not asked about the basis. Do you think Melanie’s attorney had some liability here? Absolutely!
Be sure to investigate the basis in all assets. Then there will be no surprises.
Monday, February 12, 2007
Divorcing couple can save up to $50,000 in home sale
Sophia and Lars had a 12 year old son who was going to live with Sophia in the family home after the divorce. The home had a capital gain of $984,000. They agreed that Sophia would sell the family home in 6 years when the son graduated from school. Lars stayed on the deed and their agreement was stated in their divorce decree. Even though Lars left the family home, he was able to satisfy the Ownership period and Sophia's continued residence in the house satisfies the Use test for Lars. After leaving the house, by staying on the deed, he was able to satisfy the Ownership period. When the house was sold, both Sophia and Lars were able to take a $250,000 exclusion for a total of $500,000.
This exclusion is allowed every two years. Lars could have bought his own house, sold it in two years, taken up to a $250,000 exclusion on it and still be able to take the $250,000 exclusion on the family home. It will work as long as each sale is at least two years apart.
Even if Sophia and Lars both get remarried to other partners, as long as Lars stays on the deed he can still take up to a $250,000 exclusion. Let's say that Sophia got married to Peter and Peter moved into her house. At the time of the sale, Peter would have also fulfilled the two year requirement for the Use period and he could use Sophia's Ownership period because of being married to her. So, according to the IRS, he could also take a $250,000 exclusion!
If Lars gets married to another partner, she is not entitled to take a $250,000 exclusion because she did not use the residence as her principal residence.
The savings of $50,000 comes from calculating 15% federal capital gains tax plus 5% state tax (in some states) for a total of 20% tax savings on $250,000 equals $50,000.
This exclusion is allowed every two years. Lars could have bought his own house, sold it in two years, taken up to a $250,000 exclusion on it and still be able to take the $250,000 exclusion on the family home. It will work as long as each sale is at least two years apart.
Even if Sophia and Lars both get remarried to other partners, as long as Lars stays on the deed he can still take up to a $250,000 exclusion. Let's say that Sophia got married to Peter and Peter moved into her house. At the time of the sale, Peter would have also fulfilled the two year requirement for the Use period and he could use Sophia's Ownership period because of being married to her. So, according to the IRS, he could also take a $250,000 exclusion!
If Lars gets married to another partner, she is not entitled to take a $250,000 exclusion because she did not use the residence as her principal residence.
The savings of $50,000 comes from calculating 15% federal capital gains tax plus 5% state tax (in some states) for a total of 20% tax savings on $250,000 equals $50,000.
Friday, February 2, 2007
Get money from a 401k with no penalty
Karen's divorce decree awarded her $300,000 from her husband's 401k. She could transfer the money to an IRA and pay no taxes on this amount until she withdraws funds from the IRA. But Karen needed $80,000 to pay off credit cards and other debt. Because the 401k plan withholds 20% to pay taxes, she needed to ask for $100,000.
The 401k plan withheld $20,000, sent Karen $80,000 and transferred the remaining $200,000 to her IRA. The IRS says that any money received from a qualified plan, such as an 401k, in a divorce situation only, can be spent without penalty, even if the recipient is under age 59-1/2.
Karen does have to pay the taxes on the entire amount of $100,000 but she did not have to pay the 10% early withdrawal penalty. There are specific guidelines in accomplishing this without having to pay the 10% penalty so a divorcing person needs to seek the guidance of a financial professional.
After the money from a pension plan goes into an IRA, which is not considered to be a qualified plan, Karen is held to the early withdrawal rule. If she says, “Oh I forgot, I need another $5,000 to buy a car,” it is too late. She will have to pay the 10% penalty and the taxes on the moneys taken out of the IRA.
The 401k plan withheld $20,000, sent Karen $80,000 and transferred the remaining $200,000 to her IRA. The IRS says that any money received from a qualified plan, such as an 401k, in a divorce situation only, can be spent without penalty, even if the recipient is under age 59-1/2.
Karen does have to pay the taxes on the entire amount of $100,000 but she did not have to pay the 10% early withdrawal penalty. There are specific guidelines in accomplishing this without having to pay the 10% penalty so a divorcing person needs to seek the guidance of a financial professional.
After the money from a pension plan goes into an IRA, which is not considered to be a qualified plan, Karen is held to the early withdrawal rule. If she says, “Oh I forgot, I need another $5,000 to buy a car,” it is too late. She will have to pay the 10% penalty and the taxes on the moneys taken out of the IRA.
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