Melissa Etheridge recently made headlines with her break up from Tammy Lynn Michaels, saying “I’m for gay marriage, because I’m for gay divorce” while on the Joy Behar Show. Etheridge reveals that she had to pay twice as much to end her relationship – a domestic partnership – because of tax issues and legal problems facing some same-sex couples. This is one high-profile example of what I call the “Gay Divorce Tax,” which could affect anyone ending a civil union, domestic partnership, or gay marriage.
While I’m sure splitting a lifetime of assets is painful enough, did you know that generally speaking, the process of divorce is not taxable for straight couples? On the other hand, gay couples could face all the “fun” of a traditional divorce while also getting hit with taxes.
The issues involved here are very complex, and often guidelines from the IRS are somewhat unclear. These issues and complexities could make it hard for same-sex couples to find lawyers, financial planners, and accountants who are up to date on the ever-changing rules, laws, tax statutes and more. I’ve seen people make important (and expensive) decisions based on bad or incorrect information.
To give you an example of the Gay Divorce Tax , consider what happens when splitting a retirement account. Eric and John are both 50 years old and are breaking up. As part of the divorce, they need to split a $500,000 401k that is in Eric’s name. If they were straight, they could do QDRO (Qualified Domestic Relations Order) and relatively easily split the 401k in half. Both would end up with $250,000 each in a retirement account. But the QDRO wouldn’t be available for Eric and John. To pass the money from Eric to John, first they are subject to the Gay Divorce Tax.
Eric would have to take a taxable withdrawal from his 401k. The $250,000 would be subject to income taxes and penalties that could be 33% or more. It could include a 10% premature distribution penalty, state income taxes of 9.3% in California, and it may be subject to gift taxes as well. If the divorcing couple proceeded this way, Eric could be hit with tax bill of $75,000 or more before even dealing with gift tax issues. Also, keep in mind that the leftover money that John does receive will no longer be in a tax-deferred retirement account such as an IRA or 401k, and there aren’t options to quickly get large amounts back into tax deferred accounts.
The Gay Divorce Tax is just one reason same-sex couples need to talk about divorce. As a group, we need to become more educated. Dealing with marriage and divorce is a relatively new phenomenon for the LGBT community. Some people I’ve talked to were shocked at the complexity and cost. Most aren’t aware at all of the Gay Divorce Tax.
Stories of state courts refusing to grant divorces to gay couples that were married in other jurisdictions get a lot of attention. Meanwhile, the unfair tax penalties go less noticed.
We’ve never had federally recognized marriage, so most people do not truly understand the financial obligations that come with it. Many of us faced with a divorce will be shocked by the process and its dismal results. While the challenges we face may seem unfair, they are what they are.
Being aware of this reality will help couples make the appropriate decisions to map their future lives together, and preparation could make the difference between living happily ever after, or sending a nice Gay Divorce Tax check to the IRS.
DAVID RAE, CFP® is a retirement planning specialist with Trilogy Financial Services, specializing in the needs of the LGBT community. Follow him on Twitter @davidraecfp or via his website, www.davidraefp.com.
Securities and advisory services offered through National Planning Corporation(NPC), Member FINRA,SIPC, a Registered Investment Advisor. Trilogy and NPC are separate and unrelated entities. NPC is not engaged in the rendering of tax or legal advice.