Key Financial Tips When Getting a Divorce
Long-term trends show that divorce is increasingly expensive, time-consuming, and more frequent with divorce rates ranging from 40% to 50% depending on the state and age of the couple. We’ve all seen clients, friends, or family financially and emotionally decimated from going through a divorce. Oftentimes, one or both of the divorcing couple aren’t aware of the financial implications of the divorce settlement. Understanding the financial implications of divorce can make an already emotionally difficult situation easier to navigate. Here are some financial issues to consider for anyone going through a divorce.
Inventory assets, liabilities and income immediately.
If you’re thinking about getting a divorce, you’re going to want to gather documentation on both spouses’ income and assets as soon as possible. If the divorce becomes acrimonious, getting a hold of the documentation might become exponentially more challenging. The document collection should include tax returns from the last five years, bank and brokerage statements, real estate and business appraisals, employee benefits documents, Social Security Administration reports, and personal items like jewelry and safety deposit items. Don’t forget about unique assets like frequent flyer miles, reward points, deferred compensation, art, collectibles, future tax credits, and expected tax refunds. Ideally, you’ll develop an accurate family balance sheet and income statement that can be used in settlement negotiations. You’ll also want to build a budget and understand how much does it cost every year to maintain your lifestyle.
Find Hidden Assets.
If you suspect your spouse may be hiding assets, you may want to enlist your CPA and/or financial advisor in looking for clues on tracking the assets down. For example, depreciation on Schedule C of the tax return can reveal real estate assets that may not have been disclosed and page three of a Social Security statement shows historical income. Keep in mind tax returns won’t show assets like annuities, cash value life insurance, and qualified plans that aren’t in distribution yet. A detailed review of cancelled checks, bank statements, W2s and 1099s can document assets that your spouse may not be forthcoming with. Your spouse may deny the asset exists or claim the asset was lost, but you should also be aware that there are also more esoteric ways of hiding assets like creating a false debt or transferring assets to a third party. Again, doing an inventory of marital assets early on can lower the chance of that happening.
When a spouse whose marriage is on the rocks has little knowledge of the other spouse’s finances, it might make sense to consider filing married or filing separately. This could likely result in higher tax liability, but this would lower exposure to liability if the IRS issues a notice of deficiency. Both parties are responsible for tax debts on joint tax returns unless one spouse qualifies for innocent spouse regulations.
Understand the tax implications of each asset
As each party negotiates dividing the marital assets, one of the biggest mistakes is not considering the tax consequences of each asset. For example, $1000 in a bank account is not the same as $1000 in an IRA, given that a withdrawal from an IRA would be taxed at ordinary income tax rates and possibly a 10% early withdrawal penalty, while the cash withdrawals wouldn’t be taxed. Likewise, $1000 in brokerage assets would likely be less valuable than $1,000 in a bank account, since the brokerage assets could have a cost basis much lower than $1,000 and it would be subject to capital gains taxes. It’s important to analyze each asset and take into account the tax consequences of the asset so you can view the investments apples to apples as you’re negotiating the settlement. Keep in mind that transfers between former spouses aren’t taxable, since IRS Section 1041 allows transfers to be tax-free between former spouses within one year of finalizing a divorce or within six years if it’s spelled out in the divorce agreement.
Carefully address unique assets in negotiations
There are a whole host of other division of asset issues that trip up divorcing couples, and being aware of them before the divorce settlement is finalized can save headaches down the road. Private investments are particularly troublesome since stock in privately held businesses is typically difficult to value and even harder to convert into cash. A lot of attention and analysis should be paid to dividing up retirement plans. The transferring requirements and process for calculating the value of retirement plans are different, whether it is a 401(k), IRA or defined benefit plan.
Some assets are just worth more to one party than the other. For example, Incentive Stock Options (ISOs) convert to non-qualified stock options (NQSOs) and lose their favorable tax treatment when they are transferred from one spouse to another.
Produce a pro-forma balance sheet
During settlement negotiations, we recommend modeling out any proposed asset division on a static and pro-forma basis. For example, if one spouse received a home and the other received securities, it's helpful to see what each party’s assets would look like five or ten years from now taking into account expected rates of return and tax differences.
Given the rapid growth of ownership of crypto currencies and their anonymous nature, it probably makes sense to have special clauses in the divorce settlement agreement that address this. The IRS has a heightened focus on crypto currencies, and is now focusing on transactions over $20,000. It makes senses to have documentation that addresses what would happen if previously undisclosed crypto assets are discovered and how those should be divided up.
Tread carefully on plans to sell the marital home.
For most families, their home is their largest asset, and so typically is the biggest point of contention in divorce settlement negotiations. Selling the home might be a good option for divorcing couples as they divide the marital assets, but selling could be troublesome for a number of reasons. The children are already going an emotionally difficult time with their parents getting divorced, so adding a move out of their home probably escalates the negative emotional impact of the divorce. As well, selling a home incurs large transaction costs during an already expensive divorce process. Even more, selling during a market downturn could make a potentially financially devastating process even worse. In cases where the value of the home is less than the mortgage, a short sell is an option, which could negatively impact your credit, although the credit impact of a short sale would be far better than a foreclosure.
Evaluate the pros and cons of one spouse retaining the home.
Some couples negotiate for one spouse to retain the home, while retaining the couple’s original mortgage. Before choosing this option, a thorough rent versus buy analysis should be done, so that the financial pros and cons of owning a home are thoroughly vetted. If there’s enough equity in the home and not a lot of non-home assets to divide up in a settlement, a home equity line can be used to allocate marital assets. Retaining the original mortgage can be problematic since both spouses are responsible for the mortgage from the lender’s perspective. When one spouse quitclaims their interest in the home to the other spouse, they essentially are relinquishing their benefits and rights to ownership while still being liable for the home’s debt.
Refinancing the original mortgage is a preferred solution when one spouse retains the home, but there are some potential issues to consider. Homeowner spouses may not have enough income to pay for the home themselves long-term. A thorough analysis of home affordability should be done that takes into account all post divorce expenses relative to income. Moreover, qualifying for a mortgage after a divorce could be challenging after the financial effects of a divorce, particularly for the lower income-producing spouse. Lenders will closely scrutinize sources of income, including alimony and child support. The non-homeowner spouse should insist that his or her be removed from the mortgage to protect their credit.
Determine if continuing to jointly own the home may be beneficial
There could be benefits of continuing to jointly own the home for a limited time before a future sale of the house. This option could allow for less disruption in home life for the children. As well, there are potential tax savings from maximizing the use of the $500,000 capital gains exclusion for couples. If one spouse were to take sole ownership of the home and sell, they would only get $250,000 in capital gain exclusion.
Assess Debt.
A divorcing couple’s debt can present some tricky financial issues to navigate. The simplest way to deal with debt is to allocate liquid funds and pay off the debt once the divorce has been finalized. The agreement should be very specific on who pays the debt and when. Yet, just because one spouse is supposed to pay the debt after the divorce, doesn’t mean the creditor or credit card company won’t try and come after the other spouse if payments aren’t being made. Likewise, if one spouse files for bankruptcy before, during, or after a divorce, creditors might still come after the spouse that didn’t even file bankruptcy. Moreover, the property settlement that the non-bankruptcy filing spouse negotiated could be at risk since property settlements can be discharged in a bankruptcy. However, spousal support and child support can’t be discharged in bankruptcy.
Know your Options for Alimony regarding New Tax Laws.
The TJCA will have a significant financial impact on divorces finalized after December, 31, 2018 since alimony is no longer deductible for the payer and alimony income no longer taxable to the receiver after that date. For couples going through a divorce now, the higher earning spouses are incentivized to finalize the divorce before the end of the year, while the lower earning spouse is incentivized to delay finalizing the divorce until 2019. For pre 2019 divorces that are modified in 2019 or later, the couple can elect to have the post-2019 or pre-2019 alimony rules apply, but they should specify in the documentation which. For New York state purposes, alimony is still considered deductible for the spouse paying alimony and considered income for the spouse receiving alimony.
For divorces finalized after 12/31/18, the new tax laws eliminate the need for recapture calculations, which were designed to avoid property settlements being disguised as deductible alimony payments. Also, the need to write separate checks for alimony and child support largely goes away under the new tax laws, since both alimony and child support aren’t deductible under the new rules. Find out more about alimony in your state.
It’s also important to understand the implication for receiving or paying alimony. The receiving spouse might want to carefully weigh the pros and cons of an upfront alimony payment versus payments over time. Payments over time could incur more credit risk and also put payments at risk if the receiving spouse were to get married.
Prepare for Child Support.
Unlike alimony, each state has its own child support guidelines that determine the amount of child support that’s paid. In addition, there are upper income limits for the child support guidelines, and parties will have to negotiate the support level if they are above those income limits. In general, child support takes into account the amount of time the child will spend with each parent, the expected income for each parent, and the amount of spousal support. So as spousal support increases, the amount of child support decreases.
As time goes on, the court can always modify child support since their primary aim is to protect the children. Even if couples decide on their own to cease child support, it’s up to the Courts to ultimately decide. For tax purposes, child support is neither deductible for the payor nor included in income for the receiver.
Don’t Forget Social Security Considerations.
While Social Security isn’t a marital asset that can be divided after a divorce, there are some divorce-related considerations. Spouses that have been married for more than 10 years can choose to take the higher of either their own Social Security benefit or 50% of their former spouse’s benefit. When a spouse chooses to take their spouse’s benefit, the ex-spouse’s benefit level is unaffected. As well, the retirement age of spouses are not connected: One spouse can take their benefits at age 70, while the other takes theirs at 62. Widow benefits are available at age 60, but only if he or she does not get remarried before age 60. A widowed person in their late 50’s may want to consider delaying a marriage to maximize their benefits.
Analyze your Health and Life Insurance.
Non-working spouses should carefully analyze their insurance options when negotiating the divorce settlement. The non-working spouse could negotiate remaining on the working spouse’s health insurance, use COBRA to pay for the health insurance up to the three year maximum, or pay for insurance on the open market with alimony or settlement assets. COBRA has its drawbacks, as health insurance is only available for companies over 20 employees, and the insured can be dropped from coverage if payments are missed. If going the COBRA route, the non-working spouse could have issues getting affordable health care once the three year period ends, so perhaps the non-working spouse might want to get private insurance immediately after the divorce until Medicare kicks in at age 65.
It’s advisable to get life insurance on the alimony-paying spouse to replace alimony payments if he or she were to pass away before payments end. To make sure payments are actually made and coverage doesn’t lapse, the alimony recipient should directly make the insurance payments. Using term insurance over whole life insurance for the duration of the spousal support would help bring costs down. Since sometimes there are issues with underwriting life insurance coverage, it’s probably a good idea to have the insurance finalized before the divorce is finalized. That way the settlement can be renegotiated if insurance on the alimony isn’t possible.
Know the Facts Regarding the New Tax Law and Divorce.
Divorce essentially becomes more expensive and incrementally financially damaging to the household under the Tax Cuts and Jobs Act (TCJA) particularly when it comes to alimony. In the past, the higher earning spouse in the higher income bracket would get a deduction and the receiving spouse in the lower tax rate would pay taxes. For example, $10,000 in alimony from a 35% bracket spouse to a 15% bracket spouse would result in $2000 in tax savings to the overall household ($3500 in a deduction for the payor and $1,500 in tax for the receiver); that’s $2,000 more in taxes under the new rules. Since the new rules won’t go in effect until 2019, couples will likely take longer to negotiate alimony and add costs to an already expensive process. Child support will remain non-deductible under the TCJA.
Moreover, couples also lost the few deductions related to divorce. Tax fees and legal fees related to receiving alimony used to be deductible under miscellaneous itemized deductions in Schedule A and are no longer are deductible. On the other hand, the child tax credit is increasing from $1,000 to $2000 and more people are eligible with the much higher income limits. It’s likely to be an even more important bargaining chip going forward. And while the TCJA eliminated claiming exemptions for dependents, divorce agreements may still want to address them since the new tax law suspended them only through 2025.
Couples may also want to consider giving the lower earning spouse IRA and 401K assets over alimony payments. Since alimony won’t be deductible and distributions from retirement are taxable, the lower income spouse will pay a lower tax rate on distributions. The household pays less taxes overall under this strategy.
And while the TCJA gives some relief on the tax brackets for divorcing couples, and divorcing couples of course will no longer be subject to the “marriage penalty” of a married couple having a higher marginal tax rate than filing as single, home ownership is incrementally more challenging under the new tax law. Less of a mortgage is deductible ($1MM to $750,000) and the $10,000 SALT tax deduction makes a thorough ‘buy versus rent’ analysis even more important.
Consider the Impact of Divorce on Estate Planning
While estate planning might not be a primary concern during a divorce, it’s worthwhile to consider some of the estate planning issues during the divorce process. Having your will, powers of attorney, health care proxy, and other estate planning documents to reflect your new divorced circumstances is important. However, updating this documents during the divorce might not be allowed and could potentially make the process more contentious, so you’ll want to discuss this with your matrimonial attorney. Many states have revocation on divorce statues, which can revoke bequests to ex-spouses in some estate planning documents if a person passes before a divorced person has a chance to change their estate documents and beneficiaries. However, since many states don’t have these statues and even those that do may not address items like life insurance designations, it’s important to update your estate planning documents as soon as legally possible.
For parents with special needs, you’ll want to coordinate conversations about potential special needs trusts between your divorce attorney and estate planning attorney so the settlement can appropriate address this circumstance.
For divorcing couples with wealthy parents, it may be important to discuss the impending divorce with the parents’ advisors. In some cases, the court will subpoena wealthy parents to get a better sense of assets. If there’s an ongoing estate reduction annual gifting program as part of transitioning wealth to the next generation, this funds may be viewed by the court as income. Another estate planning considerations that may be important maybe is what happens to the children’s inheritance if a spouse remarries?
If a spouse is the beneficiary of an irrevocable trust, there are many factors that a court may consider if that trust is “protected” from a future ex-spouse and if that trust will be considered in the division of assets and determination of alimony and/or child support. Does the trust distribution standard have broad, unfettered discretion for distributions based on an ascertainable standard like health, education, maintenance and support? Is there a spendthrift provision? Is there an independent trustee? Is the divorcing spouse the only beneficiary or within a class of many beneficiaries? What does the history of distributions from the trust look like?
As technology advances, there may be unique estate planning issues to consider for some divorcing spouses. like who has rights to stored genetic material like embryos, eggs, sperm, and other relevant genetic material. Moreover, if a child is born from this genetic material after one of the spouses passes, what rights does that child to assets of the deceased spouse? Some states have enacted legislation in this area, but this is a gray area in other states.
Understand the Impact of Divorce on College Financial Planning.
Oftentimes college financial planning isn’t addressed in divorce negotiations, and this is a big mistake. We recommend spelling out in the divorce agreement as many of the college funding and college financing issues as possible. Which spouse is responsible for paying for college and for what costs in particular will they cover? How many semesters will they cover and up until what age? Are payments dependent on academic requirements?
Clearing up the answers to these questions can avoid conflict and confusion later on. The reality is that the proper planning in this area often times doesn’t get addressed given that the parties are at odds during this time.
Maximize Financial Aid for your Children after Divorce.
Proper coordination and planning can help children of divorced parents maximize college financial aid. For the FAFSA, only the custodial parent, which is the parent that the child spends the majority of the year with, reports their income and assets. Note the custodial parent has nothing to do with which parent claimed the child on their tax return as a dependent. CSS schools on the other hand look at income and asset data from both the custodial and non-custodial parents. If parents split time with the child equally, it may make sense to tip the scales and designate the less financial secure spouse as the custodial parent to maximize financial aid.
Good college financial aid strategy could mean the custodial parent receiving more of the home and less alimony, or perhaps timing the receipt of alimony outside of years that affect Effective Family Contribution (EFC). Many divorce settlements set up education trusts for college education, but this can backfire down the road since these accounts are classified as student assets and are penalized heavily under the financial aid formulas. Likewise, if the child has assets in a UTGA or UGMA account, you may want to transfer those funds into 529s to get them assessed as parental assets, or you can simply spend that money on college expenses before other funds. Perhaps it makes sense to spend the UTMA/UGMA money ahead of college on tutoring or computers.
Some careful thought should be done around funding college expenses with 529 plans. You want the non-custodial parent to hold this asset to minimize its impact on the financial aid formulas. Distributions from 529 plans can lower financial aid eligibility, so holding off on using these funds until non-assessable years (Junior and Senior years) is ideal. Likewise, distributions from 529s held by grandparents should also be delayed until the later college years, since they are considered the child’s income under the formulas. If grandparents want to contribute in the early college years, we suggest transferring the 529 or other assets to the parents, or paying for items directly like computers or airline tickets. Another strategy is for grandparents to simply to make student loan payments later down the line.
Various actions by divorcees can have unintended consequences on financial aid eligibility. Selling the family home can reclassify non-assessable home equity as assessable cash. If the custodial parent gets remarried, the new spouse’s assets and income now become scrutinized by the FAFSA, and could lower your financial aid eligibility. If the custodial parent has an interest in taking classes at a local community college, one strategy could be to enroll at a local community college. Doing so will increase college financial aid eligibility, since the EFC formula is now divided by more “students” under this strategy.
Learn more ways to maximize college financial aid for your child.
David Flores Wilson, CFP®, CFA, CDFA®, CCFC is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Managing Partner at Sincerus Advisory. Click here to schedule a time to speak with us.