Financial Considerations to Make Before Getting a Divorce

Sep 14

Divorce and financial implications financial advisor ridgewood nj poughkeepsie ny CFP Independent RIA Vision Retirement fiduciary advisor

When you’re contemplating a serious life change such as divorce, splitting hairs over armchairs and investment accounts is probably the last thing on your mind. Yet, it’s important to think about your financial future as missteps in these proceedings can have far-reaching financial implications.

Where you live can determine how assets are split

If you lack a prenuptial agreement, be sure to arm yourself with knowledge of your family’s financial situation and any applicable laws in the state where you file for divorce: as your location can determine how your retirement assets are split.

For example, nine states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) have set out to ease the often-grueling experience of splitting assets between spouses by designating those gained during marriage as “community property” (and thus owned equally by both spouses). As a result, assets that fall into this category are split evenly during a divorce. Examples of community property include real estate, personal property, savings and retirement accounts, as well as any debts acquired during the marriage.

Typically, individual assets acquired prior to marriage or inherited by one spouse (before or during the union) are not considered community property. However, these assets are commuted to community property in some jurisdictions. One of the most common ways for separate property to morph into community property is via comingling: such as when one spouse places an inheritance into a joint bank account.

Meanwhile, “opt-in” community property laws in Alaska, South Dakota, and Tennessee state that assets are split evenly if both parties agree to the same.

All other states utilize “equitable distribution,” meaning that a judge will attempt to distribute assets as fairly as possible during divorce proceedings. Under these circumstances, no set rules determine which spouse receives what (or how much).

If you own homes in more than one state, the location of your permanent legal residence determines whether or not you are subject to community property law.

Social Security benefits for divorced spouses

As a divorced spouse, you can receive up to 50% of your ex-spouse’s Social Security benefits even if you’ve earned enough credits to qualify for your own. However, you must have been married for at least ten years, divorced for at least two years, and unmarried at the time you apply to be eligible.

While you can generally start receiving Social Security benefits at age 62, the percentage you receive will depend on when you decide to claim them. To obtain the full 50%, you’ll need to wait until you reach full retirement age (67, for those born after 1961) and will permanently reduce your amount (unless you’re caring for a qualifying child) if you claim benefits any earlier. Visit the Social Security Administration’s website to calculate how much less you’d receive in this case.

A few additional considerations include the following:

· You can apply for Social Security benefits even if your ex-spouse hasn’t yet applied for Social Security.

· You can’t double-dip and collect retirement benefits based on your own and your ex-spouse’s records simultaneously (instead, you’ll receive the more significant amount of the two).

· Collecting benefits does not impact your ex-spouse’s benefits or the benefits his or her new spouse may be entitled to, as calculations are entirely separate.

Your home and divorce-related considerations

Generally speaking, the transfer of property between divorcing couples is considered a nontaxable event. However, keep in mind some scenarios that can potentially trigger a capital gains tax—especially with respect to the settlement of your home amidst a divorce.

If you both decide to sell
Should you both decide to sell a home during the divorce, you’d be assessed a capital gains tax. However, you can exclude a total profit of up to $500,000 ($250,000 each) from this tax if you’ve lived in the home for at least two of the last five years and each used it as a principal residence for at least two as well. A failure to meet these requirements means you’ll need to pay capital gains taxes on all profits, as exclusions no longer apply.

If one spouse buys out the other
The spouse who elects to remain in the home is only subject to capital gains tax when he or she decides to sell. After the sale is complete, the spouse can then exclude the first $250,000 in profits from taxes—provided he or she lived there for at least two years previously. If the spouse remaining in the home eventually decides to remarry, the $500,000 exemption is once again a possibility provided the newly married couple owns and lives in the home together for at least two years.

If you both maintain ownership, but only one remains in the home
In the case of co-ownership, it’s important to account for several risks. First and foremost, a written agreement is necessary so that the spouse not living in the home doesn’t risk losing the $250,000 capital gains exclusion in the event the home is sold.

You should also specify a likely timeframe for selling (e.g., after children graduate from college), the parties responsible for upkeep and mortgage expenses, who will take the mortgage deduction (or if it will be split), and ensuing decisions if either person finds a serious partner or one spouse passes away while still a co-owner.

Additional co-ownership risks include late mortgage payments that impact everyone’s credit, or even worse, if one spouse is sued by creditors or files for bankruptcy.

Divorce and income taxes

Filing taxes during and after a divorce isn’t always so clear-cut, as filing a joint return is—in many cases—less expensive. You may also lose eligibility for specific tax credits and/or even wind up paying higher tax rates. You’ll therefore need to keep an eye on the calendar, as your settlement date can impact how much you pay the government.

For tax purposes, your marital status on December 31st typically reflects your marital status for the entire year. Therefore, if your projected tax burden is much higher if you don’t file jointly, waiting until January 1st to settle is sometimes a money-saving option for both spouses. Keep in mind that if you do file jointly, your divorce agreement must address how you’ll manage any tax liability or expected refunds.

How to split retirement accounts in a divorce

If retirement assets comprise a significant portion of your divorce settlement, you’ll need to understand the rules of these accounts as well as their potential tax implications.

For starters, categorize each of your retirement accounts before reporting them to the courts: thereby helping you avoid potential tax and penalty complications. These categories are actually court orders establishing that one spouse has a claim to a portion of the other’s retirement plan account.

The type of retirement account determines the category. For example, qualified accounts such as 401k(s), pensions, and 403(b)s fall under the “qualified domestic relations orders” (QDROs, pronounced “quad rows”) category. Meanwhile, IRA accounts fall under the “transfer incident to divorce” category.

IRAs
Assuming an IRA account is properly categorized, no taxes are assessed on the transaction executed to split it. On the flip side, IRA owners are required to pay an early withdrawal penalty and taxes on the amount transferred.

Following the transfer, your ex-spouse assumes total responsibility for his or her amount and must transfer or deposit that money directly into an IRA within 60 days to avoid paying taxes.

401k(s), pensions, and other qualified accounts
A QDRO works in a similar manner, meaning it’s a tax-free transaction—provided the account is categorized and reported as such. The transfer recipient has a few options in this respect, including placing QDRO assets into his or her own qualified plan (tax-free) or rolling over funds into a Roth IRA: in which case the amount is taxed as a conversion but not penalized.

Next, keep in mind the timing of payouts within any retirement accounts you’re splitting: as your payment timing depends on the plan and related guidelines for defined contribution plans such as 401k(s). For example, some plans only make an immediate lump sum payout while others employ periodic payments or future lump sum payments. As for pensions, general rules dictate you are only entitled to pension payouts when your spouse reaches retirement age. Therefore, knowing payment timing is critical—especially when trying to devise a budget and assess cash flow needs for life beyond the divorce.

Taxes
Knowing how retirement accounts are taxed is also a critical component of any divorce settlement. For example, just because traditional IRA and Roth IRA accounts each have the same dollar value doesn’t mean they are split down the middle between spouses: as tax was already paid on Roth IRA contributions, meaning that once eligible, account owners can take tax-free distributions. As traditional IRAs are funded with pre-tax dollars, account owners must pay taxes on these funds when they begin taking distributions.

Splitting debt in a divorce

Each person on a joint account is liable for the full amount of any debt until the balance is paid. Therefore, obtaining a credit report from each of the three credit reporting agencies is a great first step when trying to split up debt: breaking down everything you owe in your name as well as any joint accounts you own with your spouse.

As a next step, you’ll want to cancel any joint accounts to prevent additional debt from accumulating and ideally pay off all debts before finalizing your divorce. However, since this isn’t a realistic option for most people, obligations are often split: which can sometimes lead to trouble.

Take, for example, car loans featuring both names. If the spouse responsible for payments isn’t making them, the other is on the hook for the remaining payments along with any late fees. If these situations aren’t properly addressed, they can worsen and adversely impact your credit score. In this example, the person who is actually using the vehicle should refinance the loan under his or her name.

Life insurance in a divorce

Life insurance is an often-overlooked part of the divorce process. Nevertheless, key considerations include updating your beneficiary, identifying the policy type, and protecting those who depend on you.

A policyholder can easily update the beneficiary on his or her account, provided the policy is revocable. If the life insurance policy is irrevocable, a policyholder needs the consent of his/her ex-spouse to remove that person. In some cases—especially when child support or alimony is involved—a judge may require you to keep your ex as your beneficiary to ensure he or she receives ongoing financial support.

With no cash value, a term life insurance policy is generally treated as separate property during a divorce. Alternatively, universal and whole life policies with cash value components are often treated as a marital asset.

Life insurance is also often used to help protect child support and alimony payments, particularly for the spouse who takes custody of the children after a divorce (because if a noncustodial parent isn’t around anymore, the custodial parent would lose income). This can become problematic, and as a result, a judge may decree life insurance as part of the divorce settlement.

Even when life insurance isn’t required, it may still make sense for the custodial parent to own a life insurance policy on his or her ex-spouse (especially if a lack of trust is involved) with a benefit high enough to cover a potential loss of income. A custodial parent may also want to take out a personal life insurance policy to ensure children are covered, at minimum, until they become adults (should something happen to the custodial parent).

Understand asset liquidity

Assets that can quickly and easily be converted to cash are referred to as “liquid” assets, such as savings, checking, or investment accounts. On the flip side, an illiquid asset takes much longer to convert to cash and includes items such as real estate, vehicles, and collectibles.

If you receive mostly illiquid assets during a divorce—even if the settlement seems equitable—you must remain cognizant of potential cash flow issues and therefore ensure you have enough liquid assets to cover your ongoing living expenses. In this way, you can avoid the need to take out a loan or—as a worst-case scenario—sell your home.

Other financial considerations to make during a divorce

As with most major life events, you should update estate documents such as a power of attorney and will as well as any beneficiary designations on items such as bank and retirement accounts. Even if you live in a state that automatically revokes beneficiary rights of a former spouse upon divorce, you should still update these documents—especially if you own a qualified plan such as a pension or 401(k)s. The reason why? Most qualified plans are governed by ERISA (the Employee Retirement Income Act), a federal law stating that a plan administrator must turn funds over to the beneficiary named in the documents regardless of state law.

In sum: how to prepare financially for a divorce

While splitting up is never fun, the corresponding process need not be financially ruinous. Taking the time to understand related financial impacts can help ensure you thrive in the months and years to follow.