Handling personal finances can be complicated at times; however, managing finances while also facing divorce can be even more complex. Divorce can bring an unwanted combination of emotional disruption and significant financial changes. Whether you face divorce currently or in the future, the following considerations and examples may help you reach your best financial situation as you work alongside your team of trusted advisors.
KNOWING YOUR EXPENSES
Transitioning to a single income household can be challenging, depending on the details of your financial situation prior to divorce. Therefore, knowing your expenses can help you create a suitable budget. When creating a realistic budget, consider writing down all expenses from the previous 90 days, including all payments made (mortgage, utilities, car payments and scheduled maintenance, groceries, etc.) and any long-term expenses (retirement, tuition funds, insurance, etc.). Remember to factor for inflation when creating future budgets, as the costs of goods and services are expected to increase over time.
Most states follow the principles of equitable distribution, which is defined as the manner in which property is divided at the time of divorce. Equitable distribution is not necessarily an equal division of marital property – it is a fair division – although oftentimes is a 50/50 split between spouses. When settling equitable distributions during divorce, it is important to remember that an asset’s value is not necessarily defined or limited to the current market value, and you may need to take future value or future income produced into consideration.
Consider the following scenario: June and Dan are divorcing. They have three large assets: land worth $200,000, a 401(k) worth $100,000 and a certificate of deposit (CD) worth $150,000. Dan suggests splitting their assets equally at 50 percent, so they agree to the following distribution:
- June receives the land. Dan tells her that he borrowed $150,000 against it the previous year in order to purchase the CD. They assume that if she decides to sell the land, she will profit $50,000.
- June also takes the 401(k).
- Dan takes the CD.
When June and her attorney prepare to sell the land, they are unaware that Dan originally paid $10,000 for the land 15 years prior, so now $190,000 of capital gain exists. When June sold the land, she owed $28,500 in federal taxes and $8,265 for state taxes, for a total of $36,765. While June received $50,000 for the land after paying the mortgage, she only realized $13,235 after taxes. In addition, June faces paying taxes on any withdrawals from the 401(k) – if she withdraws the full $100,000 in one year, she may only receive approximately $67,000 after paying taxes. After all taxes are paid, June’s total distribution is $80,235; however, Dan received the $150,000 CD free of tax. In scenarios like these, considering the basis of the land would have helped equitable distribution negotiations be closer to 50 percent.
CAPITAL GAINS EXCLUSIONS ON PRIMARY RESIDENCE
Due to the Taxpayer Relief Act of 1997, capital gains on the sale of a home are exempt from capital gains tax per the following exemptions: for those who are single, no capital gains tax is required on the first $250,000 made when selling a home; for those who are married, no capital gains tax is required on the first $500,000. In order to take advantage of either exclusion, the individual(s) must own the home and use it as a primary residence for two of the previous five years. As these rules relate to divorce, there are two additional rules that apply to homes purchased after 1997:
- Ownership Period – The non-owner spouse can claim the same period of time that the owner spouse owned the home.
Example: Linda marries Bill and moves into his house, which he has owned for six years. They divorce one year later. Linda is awarded the house as part of her settlement; her employer transfers her to another city, so she immediately sells the house. Linda has not owned the house for two years, but she can claim Bill’s ownership period to qualify for the exclusion.
- Use Period – A non-occupying spouse can claim the period of time that the occupying spouse used the home.
Example: Four years ago, John and Mary divorced. They both continued to own their home, and John continued to live in the home until their youngest child graduated from high school. They are now selling the home for $750,000, and the basis is $100,000. Disregarding sales costs and other expenses, Mary’s half of the sale is $375,000, and her half of the basis is $50,000. After subtracting her $250,000 exclusion, her taxable gain is $75,000. Her tax at 15 percent on the sale is $11,250. Even though she did not live in the home for four years, Mary qualified for the $250,000 exclusion because she qualified under John’s use period.
Remember to review your current beneficiaries after every important life event, including divorce. A designation of a beneficiary on an account or insurance policy supersedes any instructions in your will relating to the distribution of the assets of that account or insurance policy. Therefore, it is critical to make sure that you review your accounts and policies with listed beneficiaries to make sure they are current, and do not rely solely on updates to your estate planning documents (including your will, trusts, Power of Attorney, etc.), to provide for the distribution of your assets. If you are getting divorced, you should update all beneficiaries on your accounts once the court has issued a divorce decree (i.e., the divorce is finalized) or a court ordered separation.
Life insurance is sometimes required by a divorce decree, with term life insurance being the most common requirement. In addition, disability insurance may be required or obtained to protect human capital, or a person’s future value (i.e., future income) since disability insurance can protect spousal payments, child support and other future income streams.
Regarding health insurance, the Consolidated Omnibus Budget Reconciliation Act (COBRA) contains provisions giving certain former employees, retirees, spouses and dependent children the right to temporary continuation of health coverage at group rates. If an employer is covered under COBRA, an ex-spouse may opt to receive coverage at 102 percent of the actual employer’s premium. Although expensive, this can allow 36 months of coverage that is not subject to pre-existing condition coverage. Most people may be unaware that if an employer is not informed of the divorce within 60 days, the non-employee spouse will lose COBRA rights.
RETIREMENT PLAN DISTRIBUTION
Many retirement assets are tax-deferred, and it’s important to make sure that any distributions that are part of a divorce settlement are handled correctly to avoid unnecessary taxes and potential penalties. The distribution of assets will be stated in the separation agreement or divorce decree and that is enough to divide assets in an Individual Retirement Account (IRA) without penalty. Qualified retirement plans, such as 401(k)s or pensions, also require a judicial order known as a qualified domestic relations order (QDRO). If you are the owner of a retirement account that is being split in a divorce, you want to make sure that the right documentation (e.g. separation agreement) is in place so that the money coming out is not treated as a distribution – which would be viewed as a taxable event. If you are the recipient of a retirement account (or portion thereof) that is being split in a divorce, you want to make sure that you roll those monies into an account that has the same tax treatment (usually tax deferred) as the account it is being transferred from. You may not divide retirement assets simply by writing a check out of your retirement accounts – instead you should work with your attorney to ensure proper documentation is in place so that you do not unintentionally create a taxable distribution from your tax-deferred retirement accounts.
Social Security benefits cannot be divided by court order when getting divorced. If a couple has been married for ten years or more, the following rules apply:
- The lower-earning spouse either receives half of the higher-earning spouse’s benefit or 100 percent of his/her own benefit, whichever is greater.
- Payments do not reduce the higher-earning spouse’s benefit.
- When the primary claimant dies, the benefit that is paid out jumps to 100 percent for all the surviving ex-spouses
A divorced spouse who collects survivor benefits at full retirement age would be entitled to assistance equal to 100 percent of the deceased ex-spouse’s benefits. Full retirement age is currently 65 for those born before 1940, increasing incrementally to age 67 for those born after 1962. However, you may begin collecting divorced spouse survivor benefits once you reach age 60, or at age 50 if you are disabled1.
Divorce decrees can contain the terms of how debt is divided, but they cannot terminate the financial obligations of either spouse. A best practice would be to pay off as much debt as possible and close any joint debt accounts when getting divorced; this action minimizes how much debt is attributed to your name only. Remember that there are different substantial debt types to consider, including mortgage, auto loans, credit cards and medical bills.
If you are experiencing a divorce and have any questions related to financial best practices, please reach out to us at firstname.lastname@example.org.
(1) For more information about Social Security and retirement benefits, visit www.ssa.gov/planners.
The content in this article is for informational purposes only and does not constitute investment advice or an offer to buy or sell any security. The information in this article is believed to be accurate as of the time it is distributed and may become inaccurate or outdated with the passage of time. You should contact your financial advisor or CPA professional before making any tax or investment-related decision. Past performance does not guarantee future results. All investments may lose money.