The Big Picture for Clients in the Grips of Divorce
Advisors and other professionals who do not focus on divorce can make mistakes when working with their clients, as they do not have the needed specialized expertise.
Here are some basic financial tips on what FAs with divorcing clients might want to consider.
The deduction. There are three major financial components to a divorce: alimony (also known as maintenance or spousal support), child support and property. The duration of alimony, child support and property division are determined by state law.
Alimony is deductible by the payor and taxable as ordinary income by the recipient. Child support is an after-tax payment which is neither deductible nor taxable. The initial reaction of the spouse receiving the money is often to take it all in child support. Even though it is counterintuitive, that may not be the best solution.
The goal is to make as much money available to the family as possible. In situations when there is a large disparity in income, it often makes financial sense to have the earner of the higher wage take the deduction. This will free up more available cash for the earner of the lower wage. Presuming the payor receives a deduction at the 35% to 40% effective tax rate and the recipient pays taxes at the 10% to 15% effective tax rate, that cash differential is available for the recipient and children.
Know that certain things that seem equal are not. Depending on the divorce settlement agreement, alimony can be modified if there is a significant change in circumstances. Property, on the other hand, is a one-shot deal. In dividing property, it is important to remember not all assets are considered equal. For example, if there is $250,000 in cash and a $250,000 stock portfolio, and one spouse receives the portfolio, that might be an equal distribution — but it certainly is not an equitable distribution. Even though the securities are transferred incident to divorce, and are not taxable upon transfer, they do retain their original cost basis.
I had a client who had an excellent attorney, but he did not understand investments. The client came to me post-divorce with a gifted portfolio. The holdings were all high-quality blue chips bought post-depression. The cost basis was so low she couldn’t afford to sell the portfolio. The division was equal but certainly not equitable.
Figure out what to do with the house. If one party chooses to keep the house, it is important to make sure that party can refinance and can remove the other spouse from both the deed and the mortgage. Even if the divorce decree states that spouse A is keeping the house and spouse B is absolved of all financial responsibility, the bank does not recognize the decree. Simply put, should spouse A default, then as far as the bank is concerned, spouse B is responsible for payment.
Properly evaluate investment portfolios. IRAs and defined-contribution plans are easy to evaluate. The value of the investment portfolio is clearly indicated on the statement and can be divided by either share value or cash value on an agreed-upon date. Dividing a pension plan the same way is incorrect and can potentially cost the receiving spouse a great deal of money. The division of a pension plan requires an actuarial calculation to determine the present value of the future income stream. Actuaries calculate the value of defined-benefit plans.
IRAs do not require qualified-domestic-relations orders, or QDROs, because they are not considered ERISA assets. They do, however, require the proper paperwork so as to be divided without triggering a taxable distribution. Most of the mutual-fund companies have online instructions for dividing their particular IRAs.
Defined-contribution plans and defined-benefit plans do require QDROs, because they are ERISA plans. QDROs are generally written by professionals who specialize in them. That being said, however, there are thousands of QDROs that have been written but never filed, and consequently the assets have not been transferred. For example, if the spouse working for a company has remarried, and the assets have not been divided and transferred into the alternate payee’s name, and if the employee passes away, the former spouse can lose those assets. When dealing with a divorced client, it behooves the financial consultant to ask if all of the retirement assets have been transferred.
Today, since divorce is so prevalent and most financial consultants have clients who are divorcing, it makes sense to include another professional who has had specialized training and financial experience in divorce to be included in the financial analysis pre-divorce and possibly post-divorce.