The divorce process includes numerous decisions and significant negotiations on both sides to achieve an outcome that is potentially agreeable. These decisions often involve child custody, support, alimony, parenting plans and the division of marital assets, just to name a few.
The division of marital assets at first glance may appear to be less emotional and less complicated than other decisions during the divorce settlement. However, the reality is it can be a tremendous source of stress and emotions, depending on the temperament of both parties. While a financial advisor does not play a meaningful role in the many other decisions, the division of marital assets is an area where an advisor will add value and help set up their client for long-term success.
After determining whether the assets are marital or separate property assets and incorporating any prenuptial agreement terms, it may seem most logical to divide the marital assets by allocating 50% of all the marital assets to each spouse. Unfortunately, most times that is not what the parties had hoped. Often, both parties come to the table with some idea of which particular assets they expect or wish to keep, and it is important to consider the following key factors when dividing the assets.
Age and Earning Potential of Each Party
This will determine each spouse’s respective ability to rebuild their wealth through continued savings permitted by a comfortable and consistent income or compounded returns on investments. These assets include the value of real estate, retirement plans, investment accounts or an interest in a business or other investments.
The more time there is to rebuild their wealth, the greater the flexibility available in the settlement options — especially if both spouses are still working. If one spouse is in their peak earning years and the other spouse is no longer working and has minimal income, the lower-earning spouse needs a safety net.
The final divorce settlement typically requires one spouse (the higher-earning spouse) to pay alimony to the other spouse for a designated period. However, if alimony is not part of the final settlement, it is essential to ensure that each party has ample liquidity for their immediate living expenses post-divorce. This is especially important if one spouse is not expected to earn enough to cover their living expenses. Liquidity can be cash in bank accounts or, ideally, after-tax assets to minimize the erosion of value due to taxes.
Expected Marginal Income Tax Bracket
It is important to consider the expected marginal income tax bracket for each party post-divorce. If one spouse was the high earner of the household, and the other did not work or worked on a part-time basis, continuing in this manner post-divorce could set the stage for a tax planning opportunity.
With the non-working spouse expecting to be in a much lower income tax bracket than the higher earning spouse (even if they receive alimony since alimony is no longer taxable), an IRA may be more appealing to them since it could be a candidate for a multi-year Roth conversion strategy. It also provides a potential opportunity to negotiate certain tax deductions such as real estate taxes, mortgage interest (if they continue to own the home jointly) or claiming a dependency exemption. These deductions are more valuable to the spouse in the higher income-tax bracket.
Type of Asset (Pre-Tax vs. After-Tax)
When dividing the assets, it is crucial to consider the type of asset and whether they are pre-tax or after-tax. Retirement accounts include pre-tax accounts (e.g., traditional IRA, 401(k) or after-tax accounts (Roth IRA). Any pre-tax account will have a future tax liability that must be considered, and the net value is used when dividing the assets. As an example, a $1 million traditional IRA would not be the equivalent of $1 million of cash since the IRA has an embedded tax liability resulting in less value if withdrawn immediately. However, the IRA has the advantage of compounding investment returns on a deferred tax basis.
Asset Cost Basis
Divorcing spouses keep the same cost basis and holding period when transferring assets pursuant to a divorce. This must be closely monitored as it can have a significant impact later when selling the asset. This rule applies to the marital home, investment accounts or any asset.
One potential landmine could be the sale of the marital home post-divorce since the cost basis would also transfer to the receiving spouse. The expected $500,000 capital gain exemption on the sale of a primary residence (if filing jointly) would be reduced to $250,000 if sold post-divorce when filing as single status. Be sure to remind your clients to share with their spouse any relevant documentation regarding cost basis such as improvements made on a family home or original documentation on investments made.
If one spouse has minimal investment experience, receiving a private equity investment transferred to them as part of a divorce settlement could be very unsettling and they may not fully understand the asset. When dividing investment assets, consider each spouse’s risk tolerance. Likewise, when dividing an investment portfolio, you may be able to allocate the appropriate investments with each spouse’s appetite for risk.
Alternatively, another option is to divide each position equally. While it is not always possible to perfectly align to risk tolerance, it is important to consider this in the final decision on dividing assets. In addition, it is important to understand the unrealized capital gain that each asset will carry with it upon division as some assets may have a much larger tax upon sale.
Additional Reading: The Great Resignation or Great Retirement?
Every divorce settlement is different, and some factors may play a greater role than others in negotiations and the ultimate decision. Still, it is necessary to evaluate each factor in detail to avoid serious negative tax consequences, illiquidity and the potential to miss out on advantageous investment and planning opportunities. This requires running different scenarios to properly evaluate the risks.
The next article in this two-part series will discuss the stages of divorce and financial planning along the way.
Mariella P. Foley is a partner and wealth advisor with Round Table Wealth Management. She heads the Women of Clarity program and focuses her practice on working with women to build their financial confidence. Mariella is a Certified Financial Planner, an Accredited Domestic Partnership Advisor, and Certified Divorce Financial Analyst. Contact her at [email protected] or 908-374-2570.