The short version
- Dividing assets in a divorce can have significant legal and tax consequences.
- Each state has specific laws and practices regarding divorce, and you’ll need to work within those in your state.
- You’ll need to consider how to divide each of the multiple asset classes you and your soon-to-be ex-spouse have. There are often numerous methods.
- Loans, credit cards, and utility payments are an essential part of the financial division in a divorce.
Dividing assets in a divorce
There are dozens of issues that need to be settled in a divorce, but dividing up finances is understandably a priority.
In most states, couples can handle asset division by mutual agreement. That is, the two sides in the divorce come to an agreement about exactly how they will divide up assets, including investments.
If they can’t, each state has its own provisions for distribution.
Separate property states vs. community property states
Most states are “separate property states,” in which the courts enforce equitable distribution. It means the court will decide on a fair distribution based on each party's needs and situation. Therefore, the distribution may not be an even 50-50 split.
Forty-one states are considered separate property states. The remaining nine states are community property states. The Legal Information Institute of Cornell University defines a community property state as:
”Community property is made up of assets that come into marriage during the marriage through any means other than inheritance or gift. Regardless of how those assets are titled, assets acquired by the husband or wife are viewed as assets of the marital community… In ‘community property states' (such as California), community property belongs equally to each spouse.”
Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. (Divorcing couples in Alaska, South Dakota, and Tennessee can choose a community property division.)
Two types of asset classes: separate and marital
Whether your state of residence operates as a separate property state or a community property state, each system recognizes two types of assets: marital property and separate property.
Separate property includes assets each spouse acquired before the marriage or by gift or inheritance from a third party. Marital property includes any assets acquired during the union and the appreciated value of any separate property.
The combination of separate or marital assets and the particular property or community property laws in your state will determine the distribution of investments if you cannot reach a mutual agreement.
What happens to investments and other marital assets in a divorce?
Here are some marital assets that spouses often need to divide in a divorce.
The marital home
In many divorces, this is the biggest asset the couple needs to divide. But because it’s a single, physical asset that serves the purpose of providing shelter, it’s one of the most difficult to divide equitably.
In the simplest of situations, the divorce decree requires that the couple sell the home and split any proceeds equitably. But just as often, they need to transfer ownership from one party to the other.
If there’s a mortgage on the property, you’ll typically need to refinance the loan into your name, as mortgage lenders will not release one of the parties simply because it says so in the divorce decree. And not only will you need to refinance the mortgage into your name, but you’ll also need a reissued deed to the property with you as the sole owner.
If you’re the party giving up home ownership, be sure the refinance takes place. Simply executing a quitclaim deed that turns ownership of the property over to your former spouse will not release you from your obligation on the mortgage.
In fact, being a co-mortgagor on a property you no longer own is one of the worst financial situations you can be in. The divorce decree usually defines a specific date by which the transfer and refinance must occur.
If each spouse has a retirement plan of roughly equal value, each may simply retain their own plan. But if one spouse has a much larger plan than the other — especially if one person has no plan — they will have to distribute the savings equally.
For employer-sponsored plans, like 401(k) and 403(b) plans, the divorce court can issue a Qualified Domestic Relations Order (QDRO). This judgement orders an equitable distribution of the proceeds of the retirement plan.
Because a QDRO is an IRS-approved court order, there's no tax on the amount distributed to the other party, nor is there the 10% early withdrawal penalty tax. However, if the receiving spouse takes the funds from the plan as a non-retirement distribution they'll have to pay both. If you receive a QDRO distribution, you should set up an IRA account to receive the funds and avoid the tax consequences.
QDROs don’t apply to IRA plans. The divorce agreement determines the specific allocation of funds in an IRA account. Once again, to avoid tax consequences, the receiving party should open their own IRA account and make a direct transfer of funds from their ex-spouse’s IRA into the new account.
Be sure to discuss retirement plan distributions with your divorce attorney and a qualified tax professional.
Taxable investment accounts
Interestingly enough, dividing taxable investment accounts under a divorce can be even more complicated than separating retirement assets.
The couple must separate their assets in a joint account. This generally involves closing the joint account and establishing separate individual accounts. The assets held in the joint account will then be distributed to the two individual accounts.
But this is where investment distribution can get complicated. Closing the joint account may involve selling its investments and distributing the funds as cash to the new accounts. That could include selling profitable investment positions in the joint account, resulting in an income tax liability.
You’ll need to coordinate the distribution of funds from the joint account to the individual accounts with the account trustee and your tax professional to minimize or even eliminate the tax liability. It may be possible to transfer an even split of investment securities from the joint account to the individual accounts, eliminating the need to sell any positions.
It’s common for married couples to have multiple individual or joint bank accounts. Each account, including its respective balance, should be listed in the divorce decree or separation agreement.
Each spouse can retain individual accounts, but joint accounts will generally need to be closed with the proceeds split evenly between the parties.
Splitting bank accounts is usually easier than untangling retirement accounts and investment accounts. But if one spouse has significantly more savings than the other, they have to distribute the money equally.
Loans and credit cards
Though they’re not investments, outstanding loans and credit card debt figure significantly in divorces and can even affect how a couple divides their investments.
Couples often have more debts than they realize. Start by ordering a credit report. That will provide you with a list of all open accounts, including outstanding terms and balances.
Since debt situations are so diverse, there’s no single way to deal with them. Best-case scenario, a couple can use their non-retirement assets to pay off their debts completely. But that’s obviously not always the case.
Joint accounts: special handling required
The parties may agree to retain their accounts, but joint accounts require special handling.
Car loans are similar to mortgages: You transfer the title to a vehicle into one party’s name, and any refinancing goes under the new sole owner’s name.
The account holders should pay off and close their joint accounts, like credit cards, as soon as possible since divorces often result in conflict. You need to eliminate joint accounts because the bad credit of one of the account holders can affect the credit of the other account holder.
You should also carefully examine all duties to determine where there may be a joint responsibility. For example, you should transfer any utility accounts to the party who will take ownership of the marital home. And phone, internet and cable accounts should similarly go under one individual's name.
How to protect assets from divorce
There are a few key ways to protect your assets during divorce:
- Keep good records. This means keeping track of all financial transactions, including receipts, bills, and bank statements. This will help you keep an accurate picture of your assets and debts.
- Get a lawyer. A qualified divorce lawyer can help you understand your rights and options, and protect your interests.
- Negotiate a fair settlement. If you and your spouse can reach an agreement on how to divide your assets and debts, it will save you time and money.
- Protect your credit. During divorce, your credit may be affected if you have joint accounts with your spouse. You can protect your credit by closing joint accounts and opening new accounts in your own name.
Finally, it's important to be honest about your assets. Hiding assets during a divorce is illegal and can result in penalties. It's best to be upfront about all of your assets so that they can be properly divided.
Does a prenup protect future assets?
Yes, a prenup can protect the assets that are acquired down the road after marriage. This is especially important if one spouse plans to inherit money or property, start a business, or receive a large inheritance.
Without a prenup, these assets could be at risk in the event of a divorce. By specifying how these assets will be divided in the event of a divorce, a prenup can help protect them.
Bottom line: Get help before you divide your investments
These are some general strategies. Each state has its own laws and procedures regarding divorce. Separate property and community property are only the two most basic designations. But beyond that, there can be many other legal details specific to your state.
As mentioned several times throughout this article, you should rely heavily on professional advice to equitably divide your investments in a divorce.
This is especially important regarding taxes. A divorce brings enough financial headaches; you don’t want to create significant tax liabilities when separating accounts.