The author, freelancer, and journalist Gerald Lieberman once said: Divorce is a declaration of independence with only two signers. Despite this optimistic interpretation, it is no surprise that divorce can be emotionally and financially traumatic. It is important to have the knowledge and confidence to make informed financial decisions. Going from sharing financial decision-making to complete independence can feel daunting. Who helps ensure you are on the right track? What is a reasonable budget? Can I stay in my house? What is the impact of alimony or child support, or both? How should I deal with our debt? How do I want to distribute my estate?
Many financial questions can be solved with a calculator and proper formula, but the complexities of divorce require a more active approach. The surest way to navigate the short- and long-term challenges that lay ahead is to have a comprehensive plan based on solid, practical advice from a knowledgeable partner. The right team of advisors can help give you the confidence to make those decisions on your road to financial independence.
A pilot never takes off without knowing where she wants to land. Take the time to consider where you want to land and how you want to get there. This goes beyond mere goals. You should feel confident that you have the knowledge to chart your own path. The clarity and insight required to accomplish this demand a level of self-care that is not typically needed for most financial decisions. Following a divorce, you may be thinking about everyone other than yourself—your children, parents, family, and loved ones. We are all familiar with the airline mantra, in the event of an emergency, please put on your oxygen mask before assisting others. They say this because if you run out of oxygen, you cannot help anyone else. Your financial health is no different.
The Family Home
Among the most emotional assets in a divorce is the family home. This asset has implications beyond memories and can be one of the most significant disrupters for dependents. The house also typically represents one of the largest marital assets. A critical decision is whether to keep the marital home. This is not a black or white question. You may want to keep the home until the children move out or go to another school. Perhaps you have the liquidity to convert it to an income-producing investment property rather than selling it. The costs of maintaining the marital home remain constant with an income/asset base that is lower, creating a rather clear challenge. Often, the decision to keep the home, and for how long, can substantially impact the probability of financial success. It is incumbent on you to work with someone who can provide the proper analysis so that you can understand the potential outcomes. You must also bear in mind that mortgages or other encumbrances on the property must be resolved prior to finalizing transfer of the property.
When and if you decide to sell your home, you must decide whether to buy a new home or rent one. Often, a former dependent spouse may have difficulty obtaining a mortgage, even with substantial assets. The lack of income and earning capacity can be detrimental to obtaining financing on higher-value properties.
The pros and cons of buying or renting vary depending on your specific situation. Issues surrounding this decision are typically predicated on an analysis of debt. While assets such as cash, real estate, and investments are positives on a balance sheet, debts like mortgages, credit cards, and student loans are negatives. Assets minus debts equal net worth.
Debt: The Good, the Bad, and the Ugly
Utilizing debt can be a useful tool in achieving your goals, such as owning a home or attending college. Debt, however, can undermine your goals and financial well-being when it facilitates living beyond your means. All debts should be accompanied by a plan on how to pay it off, and certain debts should be prioritized over others. The first priority is to ensure you are up to date on payments. Late payments or defaults will negatively impact your credit and spill into other areas of your life. Potential employers and landlords will check your credit, and defaulting on a mortgage can cost you your home. Once payments are up to date, debts with high rates used to bridge lifestyle or income gaps should be paid down first. Credit cards and pay-day loans notoriously have unfavorable rates and terms. Some debt, however, can actually be tax- and cost-efficient. You should understand your rate, terms, and payoff plan for each of your debts. Becoming individually financially responsible can create unique challenges surrounding debt. Creating a balance sheet, ideally with your wealth management advisors, allows you to understand your assets and liabilities and is central to facilitating your financial health.
Taxes: Payments and Exemptions
Alimony and Child Support
There have been many changes to the tax code in the last several years. One of the most significant changes for family law is the treatment of alimony. As a result of the Tax Cuts and Jobs Act of 2017, alimony paid as a result of most divorces entered into after 2018 is not deductible by the payor and not includible in the taxable income of the recipient. Previously, alimony was deductible by the payor and included in the taxable income of the recipient. This new tax treatment for alimony is similar to the tax treatment of child support.
Because the recipient spouse often has a lower marginal tax bracket than the payor spouse, it may make sense to consider with your tax advisor the practicality of shifting more of the overall settlement from alimony to the transfer of assets, which is a nontaxable event. Thereafter, income earned on assets received will be taxable to the recipient spouse at the lower tax rate. This may allow a greater overall settlement to be enjoyed by the recipient spouse. This consideration makes consultation with your tax advisor in collaboration with your family law attorney an important part of the process.
As a result of the change in alimony tax treatment, note that the recipient can no longer treat alimony as earned income for the purpose of qualifying for deductible IRA contributions.
The changes in tax treatment of alimony also brings up the importance of reviewing withholding and estimated tax payments. Failure to properly plan for taxes associated with receiving alimony for divorces entered into pre-2018 could mean unexpected tax bills and penalties. Furthermore, those paying support for divorces entered into post-2018 should understand their payments are no longer deductible and plan accordingly.
One other note on alimony: Some states may not follow the change in federal law, making it important to consult with your tax and other advisors on the potential impact of state tax law as well.
The personal exemption that typically is taken for dependents has been suspended as part of the Tax Cuts and Jobs Act for 2018 through 2025 but is scheduled to be available again beginning in 2026. During the 2018–2025 period, the Child Tax Credit can be allocated to either parent; however, when the personal exemption returns in 2026, the Child Tax Credit must be available to the parent claiming the personal exemption for a child or children. Accordingly, it is important to work with your family law attorney and other advisors with both short- and long-term perspectives on these valuable tax exemptions and credits with both the 2018–2025 period and post-2025 period in mind, given their scheduled availability and rules around claiming them. Each situation will be different, of course, and revolve around issues including the current age of the children.
Of course, paying for college is among the most critical aspects of negotiating a divorce settlement where young children are involved. In many states, there is a legal obligation to provide for college education of children, making this an issue that must be dealt with in terms of allocating this responsibility from both practical and legal perspectives. With college costs rising significantly more rapidly than inflation each year, putting together a plan and allocating responsibility, ideally for making contributions now and on an ongoing basis to fund this substantial financial item, are critical in order to avoid significant conflict or the inability to provide for college, or both, in the college years that may seem distant and not a priority at the time of divorce.
Defined benefit pensions, which pay a guaranteed fixed amount for life, are quickly becoming a thing of the past. As a result, this is largely the first generation of individuals responsible for their own retirement. Without the ability to receive assignment of a portion of a defined benefit plan, a recipient spouse may have to rely upon either alimony or the income that can be generated from assets received in property settlement (which may include IRA or 401(k) assets, which, unlike a defined benefit plan, do not provide a fixed guaranteed annual payment), or a combination of both, along with social security benefits, to secure retirement. Unfortunately, unlike a defined benefit pension plan, alimony can be subject to change based on a variety of factors outside the control of the recipient spouse. Accordingly, it may make sense to consider receiving a greater part of the overall settlement as asset transfers as compared to alimony. Then, in concert with a wealth management advisor, acting collaboratively with your family law attorney before, during, and after the divorce is finalized, a plan can be designed to determine annual cash flow needs and how to accomplish that effectively with a minimum of risk and maximum peace of mind from the assets to be received in concert with the other sources of income.
Other than the primary residence, retirement assets, such as 401(k) plan accounts and IRAs, are often among the largest marital assets. Retirement assets are subject to unique, complex rules relating to how they can be divided. A divorce settlement will state the portion of funds the recipient spouse may receive from the ex-spouse’s retirement plan. The type of plan will determine how the account is divided. IRA assets can be simply divided by a divorce decree or legal separation agreement. Qualified retirement plans such as 401(k)s, however, require a qualified domestic relations order (QDRO). A QDRO is issued by the court overseeing the divorce. The QDRO can be submitted to the qualified plan administrator. The receiving spouse will then receive distribution options from the plan administrator.
The division of retirement assets requires close attention to detail. Failure to abide by the rules surrounding IRAs or qualified plans can result in significant tax penalties, such as income tax liability and a 10 percent penalty for recipient spouses who have not attained age 59½. Many recipient spouses prefer to roll over eligible qualified plan or IRA assets to their own personal IRA. Transferring assets to your own IRA often provides flexibility and simplicity. Nevertheless, working closely with your family law attorney, as well as wealth management and tax advisors, to understand the pros and cons of a rollover before making this decision is critically important.
Along these lines, it is also important to amend IRA and other qualified retirement plan beneficiary designations to reflect your change in marital status. Beyond merely naming children as primary beneficiaries, you should consult your legal and tax advisors to ensure that specific beneficiary designations conform to your estate plan and optimize tax deferral. Confirm that the designations will also allow your beneficiaries to utilize creditor and spendthrift protection opportunities with respect to your children’s beneficial interest in these assets. This may involve utilizing specific trusts for your children as beneficiaries of these assets.
Assembling a Team
There are opportunities to improve your economic wellbeing on your road to financial independence. The process requires navigating through ever-changing legal, tax and financial obstacles. Having the right team in place to help you chart your path is essential. There are not always clear right and wrong answers in developing your plan, and the priorities can change overtime. While it is up to you to develop your goals, the right team can give you the guidance to accomplish them efficiently.
The views expressed within this article are those of the author only and not those of BNY Mellon or any of its subsidiaries or affiliates.