Financial Planning in Divorce Situations

May 15, 2008

By Annika Ferris, CFP®, CIMA® 

In spite of the best intentions, sometimes marriages end in divorce. While this is a painful process on many levels, proper planning for the unique financial challenges of a divorce can make a big difference in the stability of your finances going forward. The following discussion highlights some of the major areas that should be addressed as part of a comprehensive plan.

Planning for Income Sources
Alimony is taxable to the recipient and deductible by the payor, while child support is neither taxable nor deductible. Certain rules must be followed to achieve the desired allocation between the two. Also, it is important to consider protecting the stream of income against the death or disability of the payor by using life insurance, annuities, and disability insurance. If there is a pension, consider the pros and cons of taking a payout now versus waiting until the former spouse retires to begin receiving a portion of the income stream. With Social Security income, remember that an individual may have the option of drawing a percentage of their ex-spouse’s Social Security benefits.

Joint Title Equals Joint Risk
Bank/brokerage accounts, credit cards, credit lines, etc. that are titled jointly are the financial responsibility of both parties, and as a result, the actions of one spouse could adversely affect the other spouse’s fi nancial security and credit. A credit report from the three credit bureaus should be obtained to identify all jointly-held accounts. Consider freezing the joint accounts (so that both signatures are required for withdrawals) or closing them.

Dividing Assets Effectively
When considering different options for splitting assets, it is important to understand that all assets are not created equal. For example, tax-deferred assets (such as 401(k) plans) are taxed much differently than taxable assets, so be sure to adjust for this so that you are comparing ‘apples to apples.’ Also, make sure that the cost basis is taken into consideration when dividing taxable assets so that one spouse does not unexpectedly incur a larger share of the future capital gains taxes. Discuss how to best utilize the tax exemption when selling the primary residence. In cases where there is a large capital gain, it may make sense to sell the home prior to the divorce being fi nalized to take advantage of the larger exemption allotted to married couples.

When splitting a qualifi ed plan or an IRA, make sure that the transfer is done properly to avoid triggering income taxes. If cash is needed from a qualified plan before the recipient is age 59½, consider taking cash distributions pursuant to the qualified domestic relations order (QDRO) prior to rolling the awarded funds into an IRA.

Filing Income taxes
If a divorce has not been finalized by year end, the individuals may file jointly or separately, depending on the situation that makes the most tax-sense and the level of cooperation. If separate returns are filed, it is important to determine how itemized deductions, exemptions and other credits will be divided.

Maintaining Health Insurance
If an individual does not have coverage through his/her own employer and is healthy, it typically makes sense to start looking for individual coverage immediately. It is possible, although not normally preferable, to continue on a spouse’s insurance for a period of time under Federal COBRA laws.