Financial planning in divorce is something most financial planners will eventually have to deal with. Fortunately, one CFP® professional gave a presentation some divorce financial planning best practices at the FPA of Minneapolis symposium. (As a side note, know that laws do vary by state.) Here are some takeaways from her talk.
Use a Balance Sheet for Property Division
A first step in the divorce financial planning process is creating a balance sheet of your clients’ assets. This is data that, says the advisor, all attorneys want to see.
Splitting Non-Marital Property in a Divorce
One category on that balance sheet will be non-marital property. Non-marital property is the exclusive property of one spouse. This can be property that a client brought into the marriage, before that client was married. Non-marital property can also be property that a client received for which their spouse has no entitlement, such as an inheritance or other gift. Non-marital property is one of the most highly-litigated areas in the realm of divorce, shared the presenter.
The key with non-marital assets is that they must be kept alone and unmolested to maintain their non-marital status. Consider an example of an investment account. The husband comes into the marriage with an investment account holding 10 shares of AAPL stock. In the event of divorce, that account and it’s content are the exclusive property of the husband, right? Wrong, says this advisor. Even automated dividend reinvestment posits that the wife has a right to that dividend growth. And if the husband is actively trading that account – selling AAPL and buying GOOG – the wife now has a much larger claim to the account value than the dividend growth alone.
A physical property (such as a home) can get even more complicated. If a husband owns a house before a marriage, any equity in that home is his. But, any equity appreciation after the marriage date is now shared. The challenge is determining the value of the property on the wedding date.
Moreover, when it comes to non-marital assets, the burden of proof is on the spouse making the claim.
Dividing Retirement Account Assets in Divorce
As a financial planner, I’m prone to throw up when viewing most 401(k) investment menu options. Why the vomiting? Because of the high-fee investment options. Fortunately, the divorce process actually presents a great financial planning opportunity: give the IRA to the husband, and give the wife a right to a comparable balance of the husband’s 401(k) balance. With a QDRO, the wife can now roll her (now) 401(k) money into her own IRA. The wife gets the ability to invest in any low-cost, diversified investment vehicle she wants with the money in her own IRA. The husband does the same in his IRA. Households assets are split, with less money being stuck in a 401(K) offering little value. The only loser in this scenario is the 401(k) company charging high fees.
Valuing and Splitting Company Stock Options, Restricted Stock Units (RSU), and Phantom Stock Units (PSU) in a Divorce
Normally, any employer-provided compensation is split if acquired during the marriage. Benefits that are vested after the divorce become the property of the employed spouse following the divorce.
Splitting a Pension in a Divorce
For the purposes of distributing a pension, the pension is given a present value (PV) and added to the couple’s balance sheet. Alternatively, the pension benefit can be split at distribution at the retirement of the breadwinner. If the pension is substantial, this warrants utilizing an actuary to value said pension. As with the stock options, PSUs, etc., what is earned after the divorce goes solely to the breadwinner.
In a shared pension, a wife cannot access pension benefit payments until the husband does. This happens when the husband enters retirement.
Dealing with Splitting a Home During Divorce
It can be argued that changing the title of a property is easy. What’s more complex is updating a mortgage.
If both spouses are on the mortgage, then updating a mortgage can be a challenge. For this, the presenting advisor offers a couple of alternatives. Firstly, if both spouses are on the mortgage, see if the mortgage lender will let one spouse assume the mortgage. This helps to protect the other spouse’s credit. For example, were the wife to assume the mortgage, the husband’s credit score would not be at stake should the wife to fail to make timely mortgage payments.
If the non-working spouse assuming the mortgage is not possible, find out if the working spouse is okay with the non-working spouse staying on the property and being responsible for the payment. This risks the working spouse (no longer in the residence) subjecting themselves to credit risk if the non-working spouse fails to pay the mortgage.
Valuing a Home During a Divorce
Additionally challenging is determining the value of a residential property. Use a neutral third-party to appraise the value of a home. The advisor adds that it would be inappropriate if the appraiser was a friend of either spouse.
One final note on splitting assets: a husband is usually emotionally tied to a pension, and his wife is emotionally tied to their physical home.
Personal Use Assets
The joint CFP® CDFA designee classifies personal use assets as the cars, the couches, and even the miscellaneous sentimental ornaments. She cautions that there can be a lot of emotion tied to these assets – even though their dollar value may be relatively limited. For this reason, you want to encourage clients to move through the process of dividing personal use assets quickly. Otherwise, clients will literally pay for it in the form of increased legal fees. And that simply doesn’t make sense.
One way to speed up the process of splitting up personal use assets is to simply treat these items like anything else on the clients’ balance sheet. Value the item as the market would.
Valuing Personal Use Assets in Divorce
The only caveat here is to make sure that you’re using the same metric. If the item in question is a car, make sure both clients are using Kelly Blue Book to determine the value of a vehicle. This works better than the husband using Kelly Blue Book, and the wife using Edmunds, etc.
Liquidity Needs in a Divorce
72(t)(2) to Help with Cash Needs in Divorce
You may have heard of the 72(t)(2)(A)(iv) provision of the tax code – allowing an individual to remove funds from their tax-advantaged retirement account while avoiding the early redemption penalty. But have you heard of the 72(t)(2)(C)? I hadn’t – and certainly don’t remember that being in the CFP® curriculum.
The 72(t)(2) allows the wife to withdraw funds penalty-free at the issuance of a QDRO. This is critical because divorce creates immediate liquidity needs.
It’s important to stress that the 72(t)(2) is a one-time opportunity. The distribution must be made before the funds are rolled into an IRA to avoid the early distribution penalty.
Keep Credit Accounts Open During Divorce
A common client instinct, reports this divorce expert, is to close joint credit card accounts. This is because one spouse may be fearful that the other spouse may go on a spending spree at the expense of the other more frugal spouse.
Consider keeping credit accounts open during the divorce process, as one or more clients will need liquidity to fund their life transition. If there is a trust issue with regards to a possible spending spree, then consider that any joint debt be assigned to the more responsible spouse. When the clients are dividing their assets, the balance sheets can be equalized given this debt assignment. To be compensated for paying this debt, the spouse paying the debt can acquire a larger proportion of investable accounts, etc. The more responsible spouse can assume the debt and make timely payments, positively impacting the credit of both spouses.
Taxes can add another layer of complexity to a divorce. When splitting assets, consider splitting taxable assets right down the middle. Such a process is equitable and helps avoid some of the more complex tax calculations.
Investment Portfolio Cost Basis
In the process of delineating certain spouses to receive certain investment accounts, know that the cost basis of the investment is transferred to the receiving spouse. There is no step-up in basis as there is in certain inheritance situations.
Tax Benefits on Minors
Some aspects of the tax code offer flexibility, while others do not. Divorcing clients can agree on who will claim which credit and which deduction. Sometimes, the tax code may dictate the best arrangement – with one spouse either being in too high a tax bracket to take advantage of the tax benefit.
Child Tax Credit for Divorcing Couples
The child tax credit offers $1,000 per minor child (for 2017). However, this can only be valuable below certain incomes thresholds. The credit starts being phased out as Head of Household income reaches $75,000. For this reason, divorcing couples may agree that the child tax credit goes to the whichever spouse has the greatest income that is still below this phaseout.
One caveat of the credit is that the child must have lived with the parent claiming the credit for the majority of the year. A marital settlement agreement (MSA) can stipulate which spouse receives the credit for which child. For example, the husband can claim the credit on the son, with the wife claiming the credit on a daughter. This arrangement can be well within the confines of tax law if the son spends marginally more time with the father – and the daughter spending marginally more time with the mother.
Deciding on the Child Exemption for Divorcing Parents
Like the child tax credit, the child exemption may be forfeit because of the alternative minimum tax. For this reason, divorce financial planning may include opting to declare which spouse may claim the child exemption on their taxes.
Dealing with Client Emotion During a Divorce
Finally, the presenting advisor cautioned that the divorce process is fraught with emotion. As such, a lot of clients tend to make decisions based on emotion, and not information. Our job then, as financial advisers, is to educate our clients about their options for the divorce process.