Five Critical Financial Considerations to think about before the Divorce Settlement
By Alynne Zielinski, MBA, CFP, CDFA, Marcum Wealth
Financial planning is the cornerstone of an equitable and livable divorce settlement. Both short- and long-term goals change dramatically for the people involved in divorce, and there is heightened uncertainty regarding future finances. A financial plan models the risks that need to be mitigated, the financial support necessary, and frames asset distribution for educated decisions.
Divorce financial planning begins with gathering existing data, including net worth statements and income sources. In addition, the principals will be surveyed to understand their new needs, wants, and wishes. The robustness of the divorce financial plan depends upon the thoroughness of this information. During the data-gathering phase, the divorce planning advisor will perform an in-depth analysis of the finances and weigh those against the client’s requirements.
CREATE A BUDGET
The next phase is to build a financial perspective around the post-divorce lifestyle through an analysis of the client’s monthly budget versus cash flow. The initial prospective budget is created by the financial advisor based on the financial plan analysis, then refined in consultation with the client. Once the budget has been refined, the annual and monthly cash flow can be completed along with the long-term net worth projections. This information provides a framework for the initial settlement proposal.
ANALYZE SETTLEMENT OPTIONS
Settlement options require a substantive analysis of the after-tax implications of the client’s financial assets. It is important to understand that the value of financial assets can differ greatly in post-divorce net amounts due to varying tax consequences. For example, the sale of certain financial assets could have significant capital gains due to lower acquisition costs. Or, some financial assets could be restricted to an event or perhaps constrained by age or time.
The asset analysis will be both detailed and strategic in order to provide a thorough and equitable financial distribution.
The following are some of the more common accounts and the characteristics of each.
Examples are Savings, Checking and Investment accounts. All three incur taxes in the year transactions occur. While savings and checking accounts are typically straightforward, investment accounts can be tricky. Holdings in investment accounts can be considered liquid assets, readily available to be used when needed.
However, any time you sell an investment in a taxable account it incurs a capital gains tax. Splitting the assets 50/50 may not be an equitable solution if Spouse 1 receives $500,000 of a stock with a cost basis of $480,000 while Spouse 2 receives $500,000 of a stock with a cost basis of $100,000. This is not an equitable split as Spouse 1 is actually receiving $494,000 (($500,000-$494,000)*20% = $4,000 Capital Gain Tax) while Spouse 2 is receiving $420,000 (($500,000-$100,000)*20% = $80,000 Capital Gain Tax).
Traditional IRA Accounts
These are tax deferred accounts meaning they are taxable as ordinary income when assets are withdrawn. Assets in these accounts cannot be withdrawn before age 59 1/2 without a 10% penalty. If the client has an immediate need for assets, is under age 59 1/2 and is only being offered IRA assets as part of a settlement, then a calculation should be done to true up the division of assets to account for the 10% penalty.
Roth assets grow tax-free and are tax-free upon withdrawal. The same 10% penalty occurs in these accounts if assets are withdrawn before reaching 59 1/2.
Examples include retirement plan assets held in an employer’s plan. These plans require a Qualified Domestic Relations Order (QDRO) to direct the employer to distribute assets to a former spouse. It is important to have a copy of the 401(k) plan in hand to verify its rules and understand whether you have to ask for an amount or a percentage when filling out the QDRO. Since the value at the time of divorce is known, the amount or percentage is straightforward.
Similar to a 401(k), these plans are also split using a QDRO. These are a bit more complicated as the future value of the pension is not known at the time of divorce. For that reason, a future value must be calculated using coverture to determine the marital portion.
QDRO pitfalls to avoid:
- Not having the plan in hand to verify its rules.
- Stating an amount when the plan asks for a percentage and vice versa.
- Not using the coverture calculation to determine the marital portion of a pension.
- Not defining the date of division of assets.
An important aspect of the financial planning process is mitigating unforeseen events that may include the moneyed spouse passing away before alimony or child support payments are complete. For this reason it is important to build scenarios in financial planning that model the efficacy of existing life insurance and any restructuring or additions of new life insurance. Part of the restructuring will entail a beneficiary review of all assets and updates to wills, trusts and other financial documents.
AFTER THE DIVORCE
Once the divorce settlement has been reached, the actual financial planning begins. The financial planner works with the client to solidify the new monthly and annual budgets, and creates the projected net worth and cash flow statements. Investments are reassessed and reallocated as needed into appropriate risk and timeframe buckets, then are routinely monitored for adequacy. In addition all beneficiaries are updated, names are removed from liabilities no longer belonging to the client, and the QDRO submission and implementation is verified.
The financial plan is meant to be a guideline throughout the divorce process. It is prudent to run many different scenarios based on the options available to the client to develop a solution that is both equitable and livable for each party.
Divorce is emotional. The financial plan alleviates hasty decisions that may jeopardize future well-being, help divorcees stay on a clear, decisive path, and eliminate emotional decisions to protect their future and the future of their children.
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