Financial Fallout from Divorce

In America, there is a divorce every 13 seconds; approximately half of all marriages end in divorce. Given the high number of divorces, it is important to understand the financial implications of taking one financial unit, a married couple, and splitting them into two separate financial units, two individuals. Most people involved in a divorce seek professional council from a divorce attorney, but I would also suggest that prior to the divorce both spouses should also seek advice from an experienced financial professional knowledgeable in the nuances of the financial split. Working in tandem with the attorney, the financial planning professional can anticipate potential financial issues the attorney may not consider.

Splitting Assets is the first issue everyone considers and it first it seems easy to find a fair split based on current values. However, not all asset values are equivalent. For example, is this fair? What if one spouse receives a savings account with $100,000 while the other spouse receives a mature fixed non-qualified annuity with $100,000? On paper the values are equivalent, until you consider taxes. Withdrawing the $100,000 from the savings account has no tax implications. Interest received on the savings account is taxed every year as it is accumulated but annuities are tax deferred. When interest is paid in the annuity no taxes are due until the value is withdrawn. Let's say that in our example, the $100,000 annuity has grown from an initial deposit of $70,000. If the $100,000 is withdrawn the owner has to now pay taxes on the $30,000 of growth. If the owner is in the 25% tax bracket the annuity's net value is $100,000 minus 25% of $30,000 which is $92,500. So the two assets are not really equivalent.

Alimony and Child Support are typically the second financial considerations the divorcing spouses address. Experienced attorneys are well qualified to guide their clients in negotiating a fair agreement which fits the particular situation.

There are many Tax Issues to consider. Alimony paid is tax deductible by the person who writes the check and taxable to the recipient. Child support paid is generally not tax deductible to the payer or taxable to the recipient, however when child support is shared through custody, financially, or a combination of both an agreement has to be reached as to who gets to claim the child(ren) on their tax return. Our tax code provides no guidance on this other than a child may only be claimed by one parent and that the parent must provide support to the child. Common agreements include alternating years or, if multiple children are involved, splitting the children between parents for tax purposes. But this is just for the care and feeding of the kids, education is a different situation we will get to in a moment.

While we are on the topic of tax issues, one area I often see overlooked in the divorce agreement has to do with current year income. In a recent case, the married clients had a brokerage account with several investments in it. The divorce agreement directed that the account be split into two individual accounts, each to receive half of each investment. Again at first glance, everything seems fair and equal. But at the end of the year the joint account generated a 1099 for income received prior to the account being split. Since the former husband's social security number was listed first on the account, he was burdened with income tax from the 1099. Unfortunately the divorce agreement did not address this issue and he decided it wasn't worth the time, frustration, expense and potential ramifications to ask his ex-wife to pay her fair share after the fact.

Retirement Plans are typically divided using a Qualified Domestic Relations Order (QDRO) which directs retirement plan trustees to take retirement money from one spouse and transfer it to the other spouse without creating tax implications. With QDRO's, particular care needs to be taken in the exact wording agreed upon in the divorce agreement. I remember a particular case in 2000 where I was working with the ex-wife. Her ex-husband had approximately $200,000 in his 401(k) and their divorce agreement dictated that she was to receive $100,000 from his 401(k). You may recall that the markets were falling in from 2000 until mid-2002. She took her time and waited patiently to file the QDRO. Out of spite, she intentionally waited and let her former husband take the market risk until the markets began to show signs of improvement and only then did she request her $100,000 from his 401(k)! Suppose the original $200,000 was now worth only $150,000; she takes her $100,000 and he is left with $50,000. What was supposed to be a 50-50 split ended up as a 1/3 – 2/3 split. Of course, if the market was rising the reverse would have been true but I doubt she would have been as patient in that situation. I generally suggest that QDRO's be declared in percentages instead of dollar values to avoid such exploitations. Another often overlooked aspect of QDRO's are any fees or charges assessed when making the withdrawal from a retirement account. A typical example would be surrender charges from an IRA held in a variable annuity. Especially if the QDRO directs a specific dollar amount, the spouse surrendering the money may have to withdraw more than the amount transferred to cover those charges.

If there are any debts of the marriage, the divorce agreement typically details who will take responsibility for particular debts. But the divorce agreement is not binding to the lender. Suppose a couple has a joint credit card with a balance of $2000 and a credit limit of $10,000. The agreement may direct that one spouse has responsibility for that account but if the other spouse does not have their name removed from the account, the lender could seek repayment from them even for charges made after the divorce. Typically the innocent spouse is unaware of the issue until the lender tracks them down demanding payment or they find their credit scores damaged enough to deny them access to credit of their own.

Finally, let's revisit Education for the children. As with most other aspects of a divorce, there is no standard agreement. It is entirely negotiable between the two parents. One of the best starting points I have ever seen was a formula given to me by an attorney when he was representing the client in the divorce and they had engaged me to consult with them on the financial issues. Here is the formula:

A = the cost of attending the in-state public school to include tuition, fees, books, room and board

B = any scholarships and grants awarded to the student excluding student loan programs

C = A – B … the net cost of attending school after scholarships and grants are considered

D = ½ C … each parents financial responsibility

E = 1/3 A … the maximum amount a parent can be ordered to pay pursuant to Iowa code

As long as the student attends an in-state public school each parent pays the lesser of D or E. If the student attends an out-of-state school or a private university, A then becomes the average cost of University of Iowa, Iowa State University, and University of Northern Iowa and each parent still pays the lesser of D or E.

The student's responsibility is any remaining costs not paid under this formula including transportation, entertainment, clothing, and supplies

The key to successfully dividing a marriage financially is an educated understanding of all the facts and implications. It is important to get financial advice in coordination with legal advice before a divorce settlement is reached.