Planning for separation or divorce
Divorce can be an exhausting process, both emotionally and financially. As you plan for the next stage of your life, you should consider the legal, tax and financial aspects of a separation or divorce so you can make sure that your plans and legal agreements align with your goals.
Here are some factors to consider:
Do you have a prenuptial or a postnuptial agreement?
A prenuptial or a postnuptial agreement, if you have one, can determine the respective rights and responsibilities of you and your spouse in the event of a divorce. The difference between these two agreements is simply a function of timing—one of them refers to a marital agreement entered into before marriage and the other refers to one entered into after a couple is married.
In most cases, these agreements will govern the division of property between divorcing spouses. A pre-or postnuptial agreement can be especially useful if one spouse owns hard-to-value assets, such as complex financial instruments or collectibles, or is involved in a family business—frequently, the family will not want an ex-spouse to be an owner of, or even to have an economic interest in, the business. These agreements can provide a mechanism to value hard-to-value assets and allocate certain family assets to one spouse while compensating the other spouse.
Consider your cash flow and budget
In order to be prepared for a potential division of your assets, you should have a clear understanding of how much you alone spend each year, as well as both of you as a couple.
- How will your common expenses, including any school tuition, children’s summer camp, or travel, be paid for between the two of you?
- Do you have a budget for yourself?
- Will there be additional expenses for transportation between your homes, if, say, your children will need to travel between two households?
- Will your income, including investment income, be enough to maintain two households, if needed, and fund other expenses?
- If you anticipate that your total income post-divorce may not be enough to cover your expenses, you may want to explore alternatives. Could you reallocate your investments or cut back on expenses?
- Could you arrange your living situation so that travel between homes is quick and easy?
It is often difficult to maintain your lifestyle after a divorce, but thoughtful planning can help.
Don’t forget tax considerations
In a divorce, you need to think about splitting your existing assets (property settlement) and ongoing commitments to or from an ex-spouse (alimony or spousal support), especially if these items are not already negotiated and laid out in a pre- or postnuptial agreement. Each of these is different, and each may have tax implications.
Property settlement is splitting current property between spouses. In community property states, only community property (including community debt) is split at the time of divorce, generally 50-50.
Property settlement is generally tax-neutral (that is, neither spouse pays tax on the settlement) as long as certain conditions are met:
- The transfer must either occur within a year after the marriage ceases or be “related to” the dissolution of the marriage.
- To be “related to” the dissolution, the settlement generally must be made within six years after the marriage ends, and must be a result of provisions in your original or modified separation agreement or divorce decree. If your spouse is a nonresident alien, some transfers may nevertheless be subject to tax or additional conditions.
- Make sure you obtain a “Qualified Domestic Relations Order” (QDRO) before splitting qualified plans if you don’t, you could incur unnecessary taxes.
Note: while the settlement may be tax-neutral, you will want to understand whether any assets you receive have embedded appreciation—if you receive appreciated assets as part of the settlement, once you sell them you could owe capital gains tax. Consider the cost basis of each asset you may receive and any eventual tax liability you may have when you sell it.
For divorces entered into in 2018 or earlier, spousal support (but not child support) is deductible by the paying spouse and reportable as income by the receiving spouse, subject to certain conditions. Deductibility and inclusion in income could also be negotiated in the separation agreement.
However, for divorces entered into in 2019 and after, the Tax Cuts and Jobs Act of 2017 require that spousal support be neither deductible by the paying spouse nor reportable as income by the receiving spouse.
Think about obligations to or from your ex-spouse
What you owe to each other, and how you split assets, can get complicated. But asking the right questions early on could help make this process smoother. Consider the following:
- Will you have continuing obligations to your ex? If so, how will those obligations be funded if you pass away? (And how will your spouse fund them if you are the receiving party?) Individuals often turn to life insurance to fund certain obligations, some of which may terminate over time, such as paying off a mortgage or fully paying for college.
- How are assets being valued? Are you receiving mostly liquid or illiquid assets? What are your liquidity needs and will the assets you receive help you meet them?
- Do assets that are split have an equal opportunity to appreciate?
- Do assets being transferred have tax consequences that make them less attractive on a net basis?
- If one spouse is to receive the couple’s primary residence, should he or she take over the mortgage? Will the spouse qualify to take over the mortgage?
Your advisor can help navigate through these complexities and prepare you for the unexpected.