While it may seem counter-intuitive, the more common divorce becomes, the more complicated it gets. One might expect that because about half of today’s first marriages end in divorce (and around 60 percent of second marriages) the law, the process, even the outcome would become standardized, predictable even. Yet nothing could be farther from the truth.
Finances quickly emerge as the most complicated issue facing a divorcing couple, and today’s finances can be extremely complicated. Years ago, ordinary people did not own mutual funds and stock options, create blended families, or accumulate mountains of credit card and mortgage debt. Dad went to work and Mom stayed home to raise the children. Life was simple, families were simple, and divorce, although rare, was often very simple.
As a result of these financial complexities, individuals and attorneys are asking financial professionals to play an active role in assisting them with sorting through the financial details related to divorce. However, although financial planners and accountants certainly understand investments and taxes, they have little or no professional training specifically related to the financial issues of divorce. When a divorcing client asks them for assistance, many financial advisors are unable to provide critical information or offer insightful advice. Too often, the client is unaware that their financial advisors do not have the required expertise; creating unintended, even adverse results. The long-term impact of making uninformed financial decisions can be devastating to the client, their family, and their future.
Attorneys are trained to research the facts, apply the law, and navigate their clients through the legal system. Accountants calculate tax liabilities, and investment advisors build and manage your portfolio. Today, it is common for attorneys, mediators, and even judges to look to experts that are knowledgeable about the financial issues around divorce to inform this process. A Certified Divorce Financial Analyst is just that professional. Commonly referred to as a CDFA, this person is typically a financial services professional with additional training in the issues specifically related to divorce. A CDFA can assess your current assets, liabilities, and expenses. They are able to assist you with creating a household budget, proposals for division of assets and liabilities and assessing future, post-divorce needs. Without the informed input of an educated professional, you risk making serious financial mistakes that can create irreparable damage to your long-term financial condition.
Although under certain circumstances, a Divorce/Separation Agreement may be modified after the divorce is final, this modification process is expensive, time consuming and almost certainly contentious – and there is no guarantee that you will get what you are asking for! This is your divorce – and it will impact your future. Do your homework and hire qualified financial professionals who are experts in the area of divorce financial planning, and get it right the first time.
A CDFA can help you avoid the following common mistakes:
1. Negotiating to keep the “marital home” when you cannot afford it
In many marriages, the marital home is the largest, most emotional and expensive joint asset. Should you stay or should you sell? Carefully consider whether you can afford it. A home is an illiquid asset that can very expensive to maintain – mortgage, taxes, insurance, utilities, and daily operations add up quickly. Will you be able to meet all of these expenses once you are divorced? Call the utility companies and obtain your actual annual costs. Do you have money set aside in case the water heater, furnace, or air conditioning needs to be replaced? Run all of the numbers for a full year to determine a realistic evaluation of the expenses. If you do want to keep it, can you buy your spouse out of his/her half of the equity? You may be able to refinance your mortgage or take out an equity line of credit to fund the buyout. Consider a lower adjustable rate mortgage if you expect to sell a few years after your divorce. If you do sell, will there be a capital gains tax due on the proceeds? How much of the proceeds will you lose in realtor commissions, capital gains taxes, and moving costs?
Case in Point
In 2005, Heather insisted on keeping the house that she and her husband had bought when they were first married years earlier. As their marriage had been ‘on the rocks’ for a few years, the house had not been maintained and there were leaks in the plumbing, stains on the ceiling, and it desperately needed a fresh coat of paint. When she traded a portion of his 401(k) to keep the equity in the house, Heather was elated. She thought she had won until 10 months after the divorce, the water heater broke. It caused water damage in the basement and the cost to replace and install a new unit was $2,400. Heather had not anticipated this nor other expensive repairs required over the next few years. Finally, since her alimony was running out and she was losing patience, Heather decided to sell. She met with a realtor who informed her that the housing market had softened significantly since her divorce, values were down, and her equity had narrowed considerably. In addition, if she wanted to get a “good price” for the house, she was going to have to make certain repairs. When the house eventually sold, the real estate agent’s commission, and capital gains tax further reduced Heather’s proceeds. Since Heather was not married, she was not eligible for the $500,000 capital gain exclusion but rather the single rate exclusion of just $250,000. While Heather was saddled with the upkeep and expenses of this home, her husband enjoyed tax and expense free growth in his 401(k) investments, and purchased a small dwelling in a less expensive part of the state. He was elated.
2. Understanding the complications of a QDRO to divide retirement assets
A Qualified Domestic Relations Order (QDRO) is required when one spouse has a qualified retirement plan that is subject to division pursuant to the divorce agreement. A qualified retirement plan is a plan that is covered by the federal laws of ERISA and offers its participants protection from creditors. If both parties have negotiated to equalize your retirement assets by using a QDRO when you could have used assets from an IRA, you have potentially walked into a hornet’s nest. A QDRO is a complicated document that is generally drafted by a financial or legal specialist, who typically charges a fee for service ($400-$800). Once the QDRO is approved by the plan administrator, it has to be filed with the court.
The alternative to this time consuming and costly process is to take retirement assets from an IRA. Since an IRA is not a qualified plan, the IRA owner just needs to submit a letter of authorization to the financial services firm housing the IRA and a copy of the judge-signed divorce decree, and the firm will open an IRA for the receiving spouse and deposit the funds according to the divorce agreement. This can be done at no cost and typically completed within 10 business days.
Case in Point
As she was negotiating her divorce, Lisa had the choice of taking $100,000 from either her husband’s 401(k) at his job or his IRA at a local bank. Since she didn’t know that it made a difference, she chose to take the funds from his 401(k). Her agreement stated that she would pay all costs associated with transferring the retirement assets to her account. Once the divorce was over, her lawyer contacted a QDRO specialist and started the process. That was a year ago, and now the market value of the 401(k) is lower. Additionally, she paid $600 to the specialist to draft the QDRO, paid the lawyer to file it with the court twice, (the documents were lost the first time), and she still doesn’t have the money. Had she had consulted with a CDFA, she would have known to take her interest in the retirement accounts directly from the IRA. At the time he signed the divorce decree, her husband could have signed the bank authorizations allowing them to distribute the funds into her IRA. This process would have been free and she would have had her funds within 10 days of receiving the final divorce decree from the judge.
3. Realizing the importance of making the spouse who receives spousal and child support payments the owner of a life insurance contract
Life insurance is a common vehicle used to secure support in the event the ‘paying spouse’ dies. Before any divorce is final, the ‘receiving spouse’ should determine how much they would receive in total for the full term of support. If the support order is open-ended, you should do your best to calculate how much money you would need to have in the bank earning 5% interest to replace your support in the event the paying spouse dies. The paying spouse should obtain life insurance on his/her life to ensure that funds will be available upon death. If the paying spouse is obtaining a new policy then the insurance application should be approved and issued before the divorce is final. If the paying spouse is not insurable (unable to obtain life insurance) and the divorce is over, the opportunity to renegotiate or obtain different asset is lost. Also, the spouse who receives support should be the owner of the insurance policy on the paying spouse’s life. This would give the receiving spouse control over the policy to ensure that it does not lapse due to non-payment, or that the beneficiary has been changed to someone else.
4. Considering your Social Security benefits
If you were married for at least 10 years, you can collect retirement benefits on your former spouse’s Social Security record. You must be at least 62 years old and your former spouse must be entitled to or currently receiving benefits. If you remarry, you generally cannot collect benefits on your former spouse’s record unless your subsequent marriage ends by death or divorce.
If your divorced spouse dies, you can receive benefits as a widow/widower, if the marriage lasted 10 years or more. Benefits paid to a surviving divorced spouse who is 60 or older will not affect the benefit rates for other survivors receiving benefits.
If you change your name, make sure to tell the Social Security Administration and your employer. This will assure that your earnings will be properly reported and recorded in your SSA records. You should obtain a new card from SSA with your new name.
In general, you cannot receive survivor’s benefits if you remarry before the age of 60 unless the latter marriage ends by death or divorce. If you remarry after age 60, you can still collect benefits on your former spouse’s record. When you reach age 62, you may get retirement benefits on the record of your new spouse if they are higher. Your remarriage would have no effect on the benefits being paid to your children.
If you are collecting survivor’s benefits, you can switch to your own retirement benefits (if you are eligible and your retirement rate is higher than the widow/widower’s rate) as early as age 62.
5. Understanding the implications of Modifiable vs. Non-Modifiable Separation Agreements and Alimony
In most states, alimony is either modifiable or non-modifiable. When a separation agreement involving alimony is “merged” into a Judgment of Divorce, its terms are incorporated into the judgment and can be modified by the court at the request of either party. In order to prevail in a request for modification, the requesting party must show the court that there has been a “material change of circumstances” which justifies modifying the original agreement/judgment.
If a separation agreement is non-modifiable with respect to alimony, the agreement “survives” a Judgment of Divorce, and although its terms are also incorporated, it does not “merge” into the judgment. Yet the agreement stands as an independent, legal contract between the parties. As such, the contract would be litigated in a civil proceeding in Superior Court and treated as an agreement that the parties entered into voluntarily. For a court to modify the contract against the wishes of the other party is highly irregular. The requesting party must show a graver concern over and above the “material change of circumstances” standard, such as when the other party is at risk of becoming destitute.
Even if the separation agreement is non-modifiable with respect to alimony, a modification of child support is always possible, if it is determined there has been a material change of circumstances, since parents may not take away the rights of their children to receive support from either one of them.
6. Factoring the tax implications of alimony vs. child support payments
Support payments resulting from divorce receive different tax treatment depending upon whether they are characterized as “child support” or “spousal support” (sometimes referred to as maintenance or alimony). Payments classified as child support are not taxable to the receiving spouse and not tax- deductible by the paying spouse. Payments classified as spousal support or alimony are taken into income for tax purposes by the receiving spouse and deductible from income by the paying spouse.
These payments are not only tax deductible, but “above the line” adjustments to income, meaning that the paying spouse takes the deduction to arrive at their adjustable gross income (AGI) rather than adding them to their itemized deductions on Schedule A of their tax return. Divorcing spouses may be able to save money in taxes by taking advantage of this difference, but must be careful in how they structure the payments.
For these and many other reasons, any person considering (or facing) divorce would do well to consult a CDFA. As you have seen from these few examples, some of these pitfalls are very technical, and the consequences of making an ill-advised choice in any one of them can last a lifetime. Divorce is always difficult, but it needn’t necessitate a lifetime of regret. Get professional advice from the start, and make your best effort at a new beginning!