For many people, planning for a comfortable retirement is a long term challenge. A divorce can make it even more challenging. What had been a joint effort, with shared assets and expenses, now becomes an individual undertaking, with each spouse needing to cover the costs of a household and having fewer resources to tap.
The Role of a Financial Advisor
As soon as divorce seems likely, perhaps before even securing the services of an attorney, a divorcing spouse should consider meeting with a financial advisor, in particular with a Certified Financial Planner, who has the broad-based education to examine all the financial aspects of the divorce. An advisor can help prepare the spouse for the meeting with the attorney (or mediator) by furnishing her or him with the information needed to make the meeting as productive as possible. Be aware that an advisor who has been working with the two spouses as a couple will have a conflict of interest and will therefore find it necessary to sever the relationship with one spouse in order to advise the other spouse.
Relative Financial Positions
Divorcing spouses will likely be going into the divorce with an imbalance of income and assets. One may have worked less, own fewer retirement assets in their own name, and have lower earnings expectations in the future. And even after retirement, the disparity can continue well into the future. For example, if one spouse, usually the wife, took time out from, or perhaps abandoned, her career, in order to raise children, her Social Security benefit can be much lower. If the marriage lasted at least 10 years, and she doesn’t remarry, she will be entitled to only half of her ex-husband’s benefit, unless she is entitled to more on her own earnings record. If the marriage has lasted close to but not quite 10 years, perhaps the divorce could be delayed.
The court’s objective is to try to equalize the post-divorce financial positions as much as possible, so it is crucial that the judge has all the information with which to do so. In some marriages, spouses may not even be aware of each other’s individual financial assets. And some retirement assets, such as a pension plan, are less transparent than others, such as a 401(k) plan. Once all retirement assets are identified, it may be a good idea for the non-participant spouse to ask the plan administrators to put the accounts on hold and not allow withdrawals or loans, at the start of the divorce process.
Division of Marital Property
In most cases, only assets that are deemed marital property are divided in a divorce. Assets owned prior to the marriage are usually awarded to the original owner, while assets accumulated during the marriage are subject to division by the court. For example, the marital portion of a 401(k) plan may be the difference between the balance as of the marriage date and the balance as of the date of divorce, or whichever ending date is negotiated by the divorcing parties. If one spouse is covered by an employer-sponsored pension plan, that plan may be prorated if that spouse was already enrolled as of the date of the marriage.
Before the divorce terms are finalized, a divorcing spouse should consult a financial advisor or tax professional who can make her or him aware of the tax implications of a divorce. Most retirement assets are tax-deferred, so in a sense the current balance understates the true value, which reflects taxation upon withdrawal. A million dollar Traditional IRA has a lower after-tax value than a million dollar joint brokerage account. And a Roth IRA, which is not taxed at withdrawal, is more valuable than a Traditional IRA of the same dollar balance. It is important to take future taxation into account when the assets are being divided.
Qualified Domestic Relations Order (QDRO)
Once the marital property portion of retirement assets is determined, the court will decide how it is to be divided. The court may divide one spouse’s plan in a certain way in order to the equalize post-divorce retirement assets. Or it may be that each spouse retains their own retirement assets, and other assets are divided in order to equalize the settlement. But if it is necessary to divide retirement assets, a court order known as a QDRO is used. It is important to know that the QDRO is a separate order from the divorce judgment and must be separately obtained. Technically, a QDRO is used only for private employer-sponsored plans, such as company pension plans and 401(k)s, but there are similar documents that are utilized for other types of retirement accounts, such as IRAs and federal/state/municipal plans.
Usually the spouse who will be receiving the retirement assets is responsible for filing the QDRO. That process generally starts with that spouse’s attorney, who may write it up or may have it written by a QDRO provider. Once written, it is reviewed by the other spouse’s attorney and, if possible, sent to the retirement plan administrator for further review before it is sent to the court for issuance. A certified copy of the QDRO is then submitted to the plan administrator for final approval and implementation. Template QDROs should be avoided, because they are often written to favor the participant spouse in a retirement plan. A separate QDRO is required for each retirement account.
The QDRO should be filed promptly or the nonparticipant spouse may lose benefits due to the retirement, termination, withdrawal from plan, remarriage, or death of the participant spouse. If the plan is a defined contribution plan, such as a 401(k), the QDRO should make it clear that the filing spouse is an alternate payee. If it is a defined benefit plan, like a pension plan, the alternate payee should be designated as the surviving spouse.
Retirement assets that are transferred to a spouse under a QDRO are not taxed upon transfer, but are taxed when they are withdrawn or distributed. The receiving spouse can roll over the assets of a defined contribution plan, such as a 401(k), to his or her own plan to avoid immediate taxation. However, if some or all of the retirement assets received are not rolled over and are therefore subject to taxation, the 10% early withdrawal penalty will not apply if the spouse is under 59 ½. (The 10% penalty does apply to IRAs, which are not covered by a QDRO.) If any assets are rolled over and then withdrawn, the 10% penalty will apply. An ex-spouse who has received a share of pension payments may not be able to access the money until the participant spouse retires or reaches the plan’s earliest retirement age, which may be 50 or 55.
The QDRO should specify an “as of” date for separation of assets due to the changing value of the plan’s assets. That date could be the date of divorce or could be another negotiated date. The QDRO should also specify a percent division of the asset, rather than a dollar amount, which would involve a risk to either party from fluctuating market conditions. In addition, loan balances should not be overlooked, and there should be language that prohibits withdrawals before assets are separated.
If the receiving spouse elects to take possession of all or a portion of his or her share of retirement assets rather than rolling it over to his or her own plan, it will usually be more tax-efficient to receive it over multiple years to avoid paying income taxes at a higher marginal tax rate.
The 2017 tax bill changed the tax treatment of alimony, or spousal support. Prior to that, the spouse making the payment could deduct the payment, and the receiving spouse had to declare it as taxable income. For divorces finalized after January 1, 2019, spousal support is treated the same as child support. The payer can no longer deduct the payments, and the recipient no longer declares it as income.
Another tax consequence is that after the divorce, each will file an individual tax return, until remarried, which may result in the higher-earning spouse being in a higher tax bracket and the lower-earning taxpayer being in a lower bracket. If a divorce is final on or before 12/31 of the tax year, a joint return cannot be filed for that year and each must file as a single taxpayer.
Retirement Planning after Divorce
Obviously, any retirement planning that was done while married will no longer apply after divorce. It is important that recently divorced individuals work with a financial advisor to develop a new plan that incorporates their new reality to ensure that a comfortable retirement is not jeopardized in the wake of a divorce.