Gray Divorce: How to Avoid Triggering a Costly Tax Bill

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

You may be starting the next chapter of your life with a divorce. The trend where couples 50 and older are ending their marriages is growing. It’s called a “gray divorce.” The emotional transition tends to require the untangling of money, assets, and property. And there’s also how to handle taxes. What do you need to know if you’re considering a divorce or are now newly single? Sheryl Rowling is a CPA and the editorial director for financial advice for Morningstar Inc. Here’s what she had to say.

Good to see you again, Sheryl.

Sheryl Rowling: Good to see you, too.

Limiting the Financial Impact of a Gray Divorce

Hampton: It can be an emotional time when getting a divorce. How does one limit the financial impact of getting a divorce later in life?

Rowling: Getting a divorce later in life, like you said, is very emotional, but it also has a lot of financial impacts. And the best thing I can tell anyone getting a divorce, especially later in life, is to make sure that you have a divorce attorney and a competent professional team behind you.

How to Budget After Divorce

Hampton: Before divorce, one family budget covered one household. After the divorce, it sometimes needs to cover two households. What’s the first step to creating a new budget?

Rowling: Keeping in mind that you’re going to just have your share of the assets and the income. Not all expenses are going to be cut in half. Your housing, you have to pay 100% of your housing. You have to pay for your own medical bills. You have to pay for your own homeowners insurance.

And so what you need to do is scratch out a budget that shows the things that you have to spend money on, your mortgage or your rent, your insurance, your basic food, and then the items that are more optional. And you need to do that to get an idea of, “Will I be able to survive and how will I be able to survive?” It might not be perfect, but you need to start from somewhere.

What to Do if There’s a Budget Shortfall

Hampton: If they have their budget in hand, they know their fixed and flexible expenses, what if they find out that they have a shortfall?

Rowling: It’s better to find out you have a shortfall beforehand. What you need to do is look at the formula: money in minus money out. If that’s a negative, you have to either get more money in or reduce the money out. One option is working. If you’re working while you’re married, you might want to continue to work. If you are not working, you might want to get a job or at least a part-time job. You might want to consider getting a roommate.

Looking at the side that says let’s increase income. Once you’ve done that or you’ve decided that’s not for you, then you need to look at reducing expenses. And maybe that’s getting a less expensive place to live. Maybe it’s moving somewhere that’s more affordable. You have to think about the equation. If you don’t have enough money, you either have to increase income or decrease expenses or do a combination of both.

Social Security Divorce Benefits

Hampton: The timing of a divorce might affect Social Security benefits. Can you explain, Sheryl?

Rowling: Sure. If you’re married and you’ve been married for at least 10 years, the lower-earning spouse is entitled to collect 50% of the benefit of the higher-earning spouse. It does not affect the higher-earning spouse’s benefit. It’s just a benefit you get.

So, if you’ve been married nine and a half years, let’s say you’re the woman and the husband has been the major breadwinner, if you get divorced before that 10-year period, you’re not going to be entitled to half of his Social Security. So, you need to be careful that you’re not hurting yourself long term and possibly consider delaying the divorce until it’s been 10 years.

Hampton: And is that the divorce being finalized after 10 years or the filing of the divorce?

Rowling: No, it’s the finalization of the divorce, not the filing.

Gray Divorce Near Retirement

Hampton: What if someone is near retirement age? What should they keep in mind?

Rowling: If you’re near retirement age, you really need to look at the budget like we talked about and determine whether you need to continue working or not. Now, working doesn’t necessarily mean that you have to continue working a full-time job. It could be a part-time job. It could be something small. It could be going into substitute teaching. But again, you need to look at that budget and your plans for retirement before divorce might need to be different after a divorce.

Will a New Tax Filing Status Result in Higher Taxes?

Hampton: The date of the divorce matters when filing taxes, right? I mean, the IRS will consider you single for the whole year no matter when in that year you got divorced. What does it mean taxwise to go from married filing jointly to head of household or single?

Rowling: Right. That’s a great question, Ivanna. Married filing jointly can sometimes give you the lowest possible tax rate. And if you go from married filing jointly to single, if you were a high-earning spouse, your taxes are likely going to be higher. If you have a child living at home and you’re not married, you can file head of household, and that’s a pretty advantageous tax rate.

But the thing to remember is if you’re divorced on Dec. 31, you’re treated as being divorced for the whole year. If you get divorced on the following Jan. 1, you’re treated as being married the whole year prior to that. That’s another trap to watch out for. Because if you’re married at the end of the year and you wind up filing separately, you don’t get to file single.

You would have to file married filing separate, and that is the most punitive tax rate. So, you need to be very careful about the timing of your divorce and look at how that will affect your income tax filing.

How to Fairly Split Assets in Divorce

Hampton: I appreciate you stressing these dates. Splitting assets can be a challenge for a variety of reasons. However, there’s a tax angle, too. How should couples split their assets to keep it fair?

Rowling: Right. Well, when you think about splitting assets 50/50, there are a couple ways to do it. You can split everything 50/50, which may not be practical, or you can say, I’ll take investments A and B and you can take investments C and D, and that’ll work out just fine. What you need to pay attention to is also the tax gain that’s built into the assets that you’re keeping.

Let’s say you have two investments that are worth $50,000. One of them you paid $20,000 for and the other one you paid $45,000 for. If you say, “I’ll take investment A, you take investment B,” now you’re taking an asset that has more gain built in than what your spouse is getting. And so you need to be careful that you’re not taking on more than your share of the tax that’s built into these assets if you decide to sell down the road.

How to Avoid Tax Penalties When Dividing Retirement Accounts

Hampton: A gray divorced couple could have amassed a significant amount of retirement savings. How do they avoid triggering tax penalties when divvying up their 401(k)s, IRAs, and other accounts?

Rowling: Right. Again, some people will say, “I’ll just keep my retirement and you keep your retirement.” That’s great if it’s about 50/50 or if you’re able to balance it out in other ways. But very often we find that one spouse has a large retirement account, and the other spouse is entitled to part of it.

If you just say, “OK, banks, split it up,” that’s going to be a taxable event. So, whatever amount goes to the other spouse is going to be taxable to the spouse that owns the retirement account. What you have to do is you have to go to an attorney, and you have to get something called a QDRO, a qualified [domestic] relations order. And it sounds complicated, but you need to have that piece of paper to divide up the retirement accounts without triggering tax.

Pros and Cons of Keeping the Family Home

Hampton: The handling of the family home is a financial issue and a tax one. So, I’ll split this one into two questions. First, what are the financial pros and cons of keeping the home?

Rowling: Keeping the home is a really emotional topic, and typically at least one spouse really wants to keep the family home. The problem is that if you keep the family home, it means you’re keeping 100% of the equity in that home. And then to balance out the settlement, it means you’re going to get less of the financial assets.

So, if you’re going to keep the home and then get less of the financial assets, maybe that means you can’t afford to keep the home. And so you really have to consider you’re one person by yourself and now you’re going to get less of the family assets. Can you really afford to say, “I want the house?”

Selling the House and Downsizing After Divorce

Hampton: Well, let’s get into the tax issue. Couples are allowed to exclude up to half a million dollars in capital gains on their homes after a certain number of years. Talk about what happens if the person who got the house decides to sell later.

Rowling: Right, and that’s a trap that some people fall into. Let’s say that you’re the husband, and you decide you want to keep the house. And you discover after a few years that, wow, you just really can’t afford this house, so you need to sell it. Well, let’s say the house has $450,000 of gain built into it. Now if the husband sells the house, he can only exclude $250,000 of gain and he has to pay tax on the $200,000.

Whereas if they sold the house while they were together, the $450,000 is less than the $500,000, they wouldn’t have paid any tax at all. So, again, remembering that when you split assets, you’re also splitting potential tax liability. And in this case, if you’re taking the whole house, you’re giving up $250,000 of exclusion down the road if you ever want to sell the house.

Why Hire Professionals to Help With a Gray Divorce

Hampton: Sheryl, I think I know your answer to this, but what is your recommendation for uncoupling of finances during a gray divorce? Should folks DIY this or hire someone to help?

Rowling: It’s really tempting to want to avoid paying legal fees, especially if it’s an amicable split. The problem is with all of the legal and tax and financial implications, you really need to have an expert team to make sure things are being split up fairly, and you’re not going to get hit with taxes or an unexpected financial issue down the road.

So to me, the team that you need is a good divorce attorney, a CPA, a financial planner, and/or an investment manager. But you need to have this team of at least three people that can coordinate what’s going to happen as a result of the divorce and after the divorce so that you can still survive and thrive.

Hampton: Sheryl, thank you for your time today and helping us navigate what could be financial and tax traps if someone were to pursue a gray divorce.

Rowling: Right. Well, I appreciate your looking into this because I think people need this advice.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer Jake VanKersen, associate multimedia editor Jessica Bebel, and digital communications specialist Kumudini Devalla. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.