Where do you Start?
Do some financial homework first. Put together a list of your combined assets in as much detail as you can. This will include bank accounts, investments, retirement plans, real estate, personal property, collectibles, and so forth. Try to determine what each item is worth now and what it cost when you bought it. Be sure to include any loans or other debts that you have, too. Also, note the names on all accounts, and how the title is held. With this information, your next step is to determine which assets and debts are available to be divided in the divorce; your prenuptial agreement, if you have one, is the place to start for this.
Many couples enter into a prenuptial agreement before marriage; this legal document usually outlines your rights and obligations in the event of a divorce. Prenuptial agreements are unique to each couple, so if you have one, dust it off and review it with your lawyer and financial advisor. The agreement should identify assets that you brought into the marriage and those you are entitled to take in the event of a divorce. It may also outline whether spousal support (also know in some places as “alimony”) will be paid to either spouse, or what level of property settlement one spouse might expect from the other. Additionally, it may also list provisions relating to supporting children of the marriage.
Without a prenuptial agreement – or for issues not covered by the agreement – you will work with your legal and financial advisors to create proposals for division of property, spousal support, and child support. When you and your spouse reach agreement on these issues, they will be incorporated into the final divorce decree from the court.
What will you Receive from the Divorce?
You need to look at the financial aspects of a divorce from two directions:
1. What assets are available to be divided, and what are the advantages or disadvantages to receiving those assets?
2. What will your income and expenses look like after the divorce, and will these assets satisfy your needs?
This means you need to consider what assets you will receive in the form of a property settlement, and whether or not you will receive spousal and/or child support.
“Property settlement” is the term for the actual division of marital or community property assets (those that are not your own separate property). While laws and terminology vary depending on where you live, marital property is usually comprised of assets that you acquired while you were married; they may include your home, investment accounts, retirement plans, etc. Separate property – which is excluded from division on divorce – include assets that you brought into the marriage, acquired by gift or inheritance, those held in irrevocable trusts for your benefit, or assets that were identified as non-marital or separate property in your prenuptial agreement. Work closely with your lawyer to determine which assets fall into each category. You may be asked to provide documentation as to how an asset was acquired, sources of funds for its purchase, or how the income from the asset was handled.
When considering which assets to negotiate for as part of the property settlement, think about what it will cost to maintain the property and whether you will be able to cover those expenses yourself after the divorce. For instance, the vacation home may have a lot of emotional attraction, but do you really want to continue to pay for all of the upkeep, taxes, utilities, insurance and travel costs if it will strain or break your budget? Perhaps renting a place for future vacations will make more sense financially. Additionally, take careful note of which assets have loans against them. For instance, if there is a mortgage on your home, will you be able to handle the monthly payments or will you need to sell the home and find something more affordable?
Assets that you receive as part of a property settlement usually have no immediate income-tax consequences. However, you still need to consider whether there will be tax due from the use or sale of the assets, since this will reduce the net value you receive. For example, if you receive $500,000 in value from the investment portfolio, and you expect to sell the holdings, what will be left after capital-gains tax is paid from the sales proceeds? Income taxes have the potential to make a big dent in what you receive if you don’t build this consideration into your planning.
Additionally, some assets become more complex in a divorce situation than if you were to remain married. For instance, retirement plans (such as IRAs, 401(k)s and pension plans) can be divided only according to the terms of the plans and very specific steps and paperwork will be required to divide them. One spouse also may have employer compensation in the form of stock options, restricted stock and other forms of deferred compensation. These types of assets need to be considered in the total value of your combined assets but it is unlikely that the nonemployee spouse will be eligible to receive these assets; other marital assets may need to be shifted to the nonemployee spouse to balance these benefits. Should the value of these types of assets make up a large portion of marital property, a Qualified Domestic Relations Order (QDRO) may be used to formally divide the accounts so that both spouses retain the tax deferral benefits.
Spousal support is a stream of payments from one divorced spouse to the other. The entitlement to and duration of spousal support depends on where you live: state/provincial laws differ, and judges in one city may make different awards than those a one-hour drive away. If one spouse is entitled to receive and the other is able to pay spousal support, it may be structured to last for a specific period of time or for a lifetime. It is sometimes used to maintain the current standard of living for the less wealthy spouse; other times, it is used to bridge a financial gap until a former spouse can complete training or education to allow him or her to re-enter the workforce. Spousal support is usually taxable to the recipient and deductible by the payor.
If you have children together, a final piece of your divorce agreement may be child support – which refers to a parent’s legal obligation to support his or her minor children. The amount and duration will depend on your unique circumstances, but generally, child support will last until the youngest child reaches the age of majority; many agreements also require that funds be available for college costs. Child support is neither taxable to the recipient nor deductible by the payor.
Prepare a Post-Divorce Budget
Once you have an idea of your resources, it will be helpful to prepare a new budget. This will help you plan for your expenses, as well as help you define what you will need from your investment portfolio.
Sources of income may now include:
- Spousal support
- Child support
- Income from investment assets (both your own assets and those received in the property settlement)
- Trust distributions
- Salary or other earned compensation
- Distributions from family investments
- Expenses may now include:
- Spousal or child support
- Child care
- Education costs
- Insurance – health, disability, property, and liability
- Moving and additional housing costs
- Legal and other professional fees for the divorce
- Accounting fees for tax planning and return preparation
Once you’ve prepared your budget, you’ll know if you’ll have additional funds to invest (i.e., a cash-flow surplus), or if you’ll have a shortfall and will need to reduce your spending, dip into your investment or retirement funds, or find a new source of income. In either case, this will be an opportunity to work with your investment advisor to update your financial planning and asset allocation to help meet your new needs.
Other Key Steps
Check with your employer’s benefits department to determine if you need to update your insurance or other benefits elections. Divorce is considered a “life event” that allows you to make changes during the year instead of only during the annual enrollment period. Here are some areas that may require your attention:
- Insurance – Make sure that you won’t have a gap in health insurance coverage. If you were covered by your former spouse’s company plan, make sure that you have continuation under that plan if available. (In the USA, this is called COBRA coverage, and you need to have replacement coverage before the COBRA period ends.) Determine whether you should purchase or maintain life insurance policies for the financial security of your children. Also, consider whether it makes sense to carry disability insurance to protect your income stream in the event of long-term incapacity.
- Estate plan – Update your will and other estate-planning documents to reflect your current marital and family situation. The structure of your plan as a single person may be very different from what it was when you were married. You will also want to update your property and health-care powers of attorney – especially if they give your former spouse authority to make decisions on your behalf.
- Beneficiary designations – If you have life insurance or retirement plans, you may need to update the beneficiary designations if they currently name your former spouse. You may need to work with your lawyer to coordinate these with your estate plan.
- Income tax planning – Tax return filings can be complicated for the year of divorce. If you are still married on December 31, you will need to determine if you will file a joint return with your spouse or if you will file as “married filing separately”. Discuss income tax and liability protection issues with your tax and legal advisors. If your divorce will be final by December 31, work with your tax advisor to prepare a projection of your current year’s tax liability now that you are single. This should reflect your new filing status (single or head of household), dependency exemptions for children, new sources of income and deductions. You will use this projection to determine your withholding and estimated income tax payment needs.
- Mortgages and other loans – Make sure that you understand the terms of any debt that you’re assuming before the divorce settlement is complete to ensure that loans are properly titled, assets securing the loans are properly reflected, etc. Notify lenders in advance.
- Banking and credit cards – Notify your bank and credit card issuers of the divorce. Take steps to ensure that neither of you can “clean out” joint bank accounts while the divorce is pending, and pay off and cancel joint credit cards if possible. If you have not had credit cards in your own name in the past, you should consider obtaining one immediately to begin establishing a credit history for yourself. Request copies of your credit report and credit score to make sure that they are accurate.
- Passwords and privacy – For security reasons, change all of the passwords and personal identification numbers (PINs) for bank, investment, retirement, medical, and other accounts that are in your name.
These are just some of the financial factors that you should consider when dealing with a divorce; make sure you get good financial advice as well as legal advice to safeguard your financial future.
Anthony Fittizzi is a Wealth Strategies Director for U.S. Trust, where he provides financial planning advice to high-net-worth clients and families. Lynda Byrd is Market Trust Director for U.S. Trust, where she helps ensure the delivery of professional guidance, service and client experience. www.ustrust.com