Financial planning is a part of the union of marriage and the dissolution of marriage. Unfortunately, the financial ramifications of divorce are vast and undoubtedly complicate an emotionally chaotic time. You can do homework to get organized before the divorce is underway to streamline one piece of the process. There are five financial areas to focus on in anticipation of a divorce.
First, you need to focus on financial organization. In other words, you need to get your financial house in order. This phase should sound familiar because you are gathering all the same information you would need to provide to create a financial plan. You need to create or update your budget. You need to inventory the household assets, including accounts, real estate, pensions, and cash value insurance policies. You also need to inventory the debt, loans, lines of credit, and mortgages. As you inventory the assets and debt, you should keep track of the titling to delineate who owns what. Accounts will also list beneficiaries; this is important to notate in case any need to be updated.
While getting your financials organized, you listed out the household accounts. Your list of accounts should include your retirement accounts, IRAs, employer-sponsored retirement accounts such as 401(k)s, 403(b)s, and pensions. Your inventory should include the values and the assigned beneficiaries. You should have a list of your spouse’s retirement accounts as well. The all-inclusive list of retirement assets is an important starting point because these types of assets are considered joint assets. Your state will likely have specific rules regarding IRA balances.
Employer-sponsored retirement plans often account for a significant portion of a household’s net worth. The court will have a say in how your 401(k) and pension assets are divided. A qualified domestic relations order (QDRO) will be issued directing how much each person is entitled to when dividing the retirement accounts. Dividing the account according to the QDRO will allow the transfers to occur without triggering any tax consequences. You could face taxes and penalties if you attempt to transfer funds from a 401(k) outside of the QDRO.
The division of IRA accounts is a similar process, but it is referred to as a transfer incident. The division of the IRAs within the household must be court-approved before your initiate any money movements. You must be careful to ensure the transaction to divide an IRA is properly labeled to avoid triggering any tax or penalties.
Although pensions are becoming less common, don’t forget about them even if they are small. If you wait until retirement and attempt to request a portion that you felt is due to you as an ex-spouse, you will be up a creek. The pension division instructions must be hashed out and documented during the divorce.
The division of your retirement accounts, even though they are considered joint assets, is not guaranteed to be a 50/50 split. If one party entered the marriage with a balance accumulated previously, their contribution must be weighed in the division. Individual state rules will also play a role in the ultimate division of retirement assets.
The second financial area to addresses the ‘who.’ Who is involved, who should be involved, and identify their role. When thinking about who’s who, you will need to answer some questions. Are you going to be using a mediator and keeping things civil? Or do you need to involve a divorce attorney to hash the fine details out? The legal route you take will have a price tag. Consider how much you can and want to spend on legal representation throughout the process.
The third consideration is Social Security. In our blog titled ‘How to Maximize your Spousal Social Security Benefits,’ we outlined the impact divorce will have on the financial benefits you are eligible for in the future. In summary, the benefit will depend on if your ex-spouse is living or deceased.
If your ex is still alive, you are entitled to spousal benefits if:
- You and your ex-spouse were married for at least ten years.
- You have not remarried. If you remarry and are collecting benefits on your ex-spouse, remarriage will disqualify any spousal benefits.
- The divorce was finalized more than two years ago.
- Both you and your ex-spouse must be 62 or older.
If you check all those boxes, then you’re eligible for the spousal benefit, which is 50% of your ex’s Social Security amount at their FRA or your benefit, whichever is higher.
If your ex is deceased, you are entitled to spousal benefits if:
- Your marriage lasted at least ten years.
- You haven’t remarried before age 60.
- You remarried after the age of 60: If the surviving spouse remarries after 60, you have a unique situation where there are three options available:
- Keep receiving the survivor benefit based on the income of the ex-spouse.
- Take Social Security based on your work history.
- Obtain a spousal benefit based on the new spouse’s work record.
The fourth financial area to consider during the divorce is risk management. Traditionally you mitigate risk through insurance. You can immediately take a quick hit action: update the beneficiary on any of your life insurance policies. You likely had your spouse listed, is that person still the most appropriate beneficiary? Your situation may change entirely due to your divorce.
Then you can take a more in-depth analysis and take a fresh look at your insurance coverage needs spanning from health, life, long-term care, disability, and umbrella. You may need to increase or decrease your coverage due to your life changes. Especially if children are involved, you will need to reconsider your coverage and update your financial plan. Suppose you have a policy on your ex-spouse. In that case, you should consider continuing that policy to provide financial support should they pass to replace alimony and child support. Term policies are usually treated as separate assets when dividing life insurance policies. In contrast, any cash in a permanent policy is usually treated as a joint asset.
The fifth financial area to consider is your tax filing. Taxes can get complicated very quickly in a divorce. The IRS has several publications addressing the intricate details of tax filing rules and divorce. The timing of your divorce will dictate your tax filing status. Leading up to your divorce, you may file a joint return or elect to file ‘married filing separately.’ Once your divorce is final, you can no longer file a joint return.
If children are involved in the divorce, their living situation will impact your tax filing. Dependents are allocated to who they live with for the longest time during the year. Both parents may not claim the same dependent. The parent they live with for the longest is deemed the ‘custodial parent’. If the custodial parent agrees to not claim the dependent child, the other parent may claim the child on their tax return. Dependents also impact tax credits. The most common dependent tax credit is the child tax credit. Only the parent claiming the child is eligible for the child tax credit, which is $2,000 for every child under 17 (2022).
The divorce proceedings will outline if and when alimony and child support will be paid. The Tax Cuts and Jobs Act (2017) removed alimony payments as a tax-deductible item for divorces finalized after December 2018. Neither alimony nor child support payments are tax-deductible.
Divorces can be devastating emotionally and financially. Use the five financial areas to focus on early to guide you through the financial aspects of your divorce. Start with financial organization, then move to the who’s who, then Social Security, risk management, and lastly, your tax filing. Once you make it through the emotional and financial impacts of divorce, you can reprioritize your goals and begin to realign your portfolio.
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