Financial Planning for Divorced Individuals
Many articles have discussed planning for divorce and the role of the CPA in structuring alimony, child support, and property settlement agreements. Additionally, the AICPA's Personal Financial Planning Division has published a guide to planning for divorce. While it is ideal for the CPA to be involved in the process prior to the agreement, this is not always possible. For example, oftentimes a new client who is recently (or not so recently) divorced requests financial planning services after all agreements have been finalized or during the late stages of the process. The financial and tax planning needs of an individual after the divorce is complete offer special challenges.
Divorced individuals face unique issues when addressing financial needs such as retirement and educational funding. Furthermore, cash management often becomes more difficult after a divorce. For example, the amount of alimony is generally determined based upon the standard of living that existed before the divorce. While this is a noble goal, it is virtually impossible to attain. After a divorce, two households need to be maintained instead of one. This is generally the most significant factor that impacts all areas of financial planning from current cash management to retirement planning.
Tax Planning After Divorce
The tax consequences for both of the newly divorced individuals are highly significant. The divorce instrument should specify whether any transfer payments between spouses constitute alimony, child support, or a division of property. The division of marital property among former spouses has no immediate income tax consequences (i.e., no gain or loss is recognized, and the adjusted bases of the assets carry over to the recipient spouse). Child support payments are also not taxable to the recipient and are not deductible by the payor spouse. Conversely, transfer payments that qualify as alimony are deductible by the payor spouse (for adjusted gross income) and are included in the gross income of the recipient (IRC sections 71 and 215).
If the divorce agreement has not yet been completed, a primary tax-planning objective should be to minimize the combined liabilities for both individuals. If the payor spouse has a higher marginal rate, transfer payments that might otherwise be designated as child support or a property settlement may be structured as alimony so as to achieve overall income tax savings. Additionally, the structuring of divorce-related transfer payments as alimony may reduce the phaseout of itemized deductions or personal and dependency exemptions for the payor spouse. A portion of tax savings can be shared by increasing the transfer payments to the lower bracket former spouse.
Example: George and Mary Jones are divorced in 1997. George pays $40,000 in alimony to Mary in 1998. Under the divorce agreement, he is entitled to the dependency exemptions for their three children. George files as a single unmarried taxpayer in 1998 with gross income of $164,500 and $20,000 of itemized deductions. Since the 3% phaseout of itemized deductions and the phaseout of exemptions commences at $124,500 AGI in 1998, the $40,000 alimony deduction eliminates the phaseouts which would otherwise occur ($164,500 $40,000 = $124,500). George's taxable income is $93,700 ($124,500 AGI $20,000 itemized deductions and $10,800 personal and dependency exemptions) and his marginal tax rate on such amounts is 31%. George's tax savings from the alimony payment are $12,400 ($40,000x 31%). In addition, George has tax savings from the elimination of the phaseout of his itemized deductions and exemptions amounting to $1,443.
Without the alimony deduction, George's itemized deductions would be reduced by $1,200 to $18,800 ($20,000 3% of $40,000) and his personal and dependency exemptions would be reduced by $3,456 (from $10,800 to $7,344). The phaseout is 2% for each $2,500 by which AGI exceeds $124,500 in 1998. $40,000 divided by $2,500 = 16; 16 x 2% = 32%. Presumably, some portion of these tax savings will be shared with Mary.
The following requirements in IRC section 71 restrict the opportunity to convert property and child support transfer payments into alimony:
* Alimony payments must be made in cash. Thus, noncash property cannot be transferred in kind and effectively transformed from a nondeductible property settlement to an alimony payment.
* The payments must terminate at the death of the recipient. If the payments were, in fact, a division of marital property, the recipient spouse would insist that the payments continue to her estate or designated beneficiaries.
* Alimony is recaptured if payments are excessively front-ended in the initial three years. In such an event, a portion of the previously deductible alimony payments is included in the gross income of the payor in the third year and is deductible by the recipient.
* Alimony payments are treated as child support to the extent that the payments are reduced in the event of a child-related contingency (e.g., a child's death or reaching of majority).
Marital Property Tax Issues. Marital property is subject to division upon divorce or separation. The division of property has tax consequences for both parties. Both jointly owned and separately owned properties, including vested and nonvested pension interests, are considered marital property, unless the separate property was acquired by gift, inheritance, or by other means prior to the marriage. The underlying premise is that marital property should be divided in a "fair and equitable" manner, regardless of ownership.
IRC section 1041 provides tax rules governing transfers of property between spouses incident to a divorce. No gain or loss is recognized upon the transfer of property, and the adjusted tax basis of the assets carry over to the transferee or recipient spouse. For purposes of determining whether a gain or loss is long or short term upon a subsequent sale of the assets, the holding period of the transferor spouse also carries over and is "tacked on" to the holding period of the recipient spouse.
IRC section 1041 can also apply to certain third-party transfers (e.g., the payment of a recipient spouse's attorney fees where the transfer is either required by the divorce agreement or is made pursuant to written request or ratification of the recipient spouse). In such a case, the transfer of assets (e.g., stock) is treated as having been made first to the receiving spouse and then from the receiving spouse to the third party. No gain or loss is recognized by the transferor spouse; the basis of the assets carry over to the receiving spouse who then recognizes gain or loss on the deemed sale of the assets to the third party. The carryover of basis rule applies regardless of whether the adjusted basis is greater or less than the fair market value.
The tax consequences associated with the division of assets with unrealized gain or loss and untaxed property interests is an important matter in divorce financial planning. For example, one spouse's vested interest in a qualified pension plan should be discounted by any future income taxes that will be due when distributions are made. Substantially appreciated capital assets should be distributed to the lower income individual, particularly if a subsequent sale is imminent.
Dependency Exemptions And Tax Credits. IRC section 152(e) provides guidance relative to dependency exemptions for children of divorced parents. If both parents provide in total more than one-half of a child's support, the custodial parent is entitled to the exemption, regardless of the amount of support actually provided by the custodial parent.
An exception is provided if the custodial parent signs a written declaration relinquishing the exemption on Form 8332, which must be attached to the tax return of the noncustodial spouse. In the event of joint custody, the parent who has custody for the greater portion of the year is generally entitled to the exemption, unless a waiver is used to transfer the exemption to the other spouse.
When a child reaches the age of majority (18 or 21, depending upon state law), the parent who provides more than one-half of the support is entitled to the dependency exemption, unless there is a specific provision to the contrary in the divorce instrument.
If the objective is to minimize income taxes for both individuals, the dependency exemptions should usually be transferred to the spouse who has the highest marginal tax rate. An exception should be noted where the highest marginal tax rate of an individual's AGI is within the phaseout range (e.g., $124,500 to $247,000 for an unmarried individual in 1998). In such case, the higher income individual will receive little or no benefit from the dependency exemptions, and the lower income former spouse should retain the exemptions.
It is possible to determine annually which spouse will use the dependency exemptions based upon the relative incomes of each. However, such disclosure among the parties may be a source of controversy, because the amount of child support is always open to review by the domestic relations court and may trigger future disagreements between the divorced individuals.
The Taxpayer Relief Act of 1997 provides for a child credit of $400 per child in 1998 and $500 thereafter for qualifying children under age 17 [IRC section 24(c)(1)(A)]. The child credit is allowed only to the parent who claims the dependency exemption. It is phased out by $50 for each $1,000 of AGI in excess of $75,000 for an unmarried individual and $110,000 for a married person filing jointly. Thus, it may be preferable to shift both the dependency exemption and the child credit to the lower income former spouse.
The child care credit should also be considered relative to the decision as to which of the divorced parents should claim the child credit and the dependency exemptions. The child care credit is available only to the parent who maintains a household for a dependent child under age 13 or an incapacitated dependent or spouse [IRC sections 21(b)(1) and 21(e)(1)]. The custodial parent is eligible to claim the child care credit even if the dependency exemption has been transferred to the noncustodial parent.
Divorced individuals should also consider the availability or utilization of child educationrelated tax credits, IRAs, and other deductions. These incentives include deductions for student loan interest, the education IRA, and the Hope and Lifetime Learning credits discussed later.
Filing Considerations. If divorcing individuals are still married at the end of the year, a joint tax return may be filed, or the individuals may file separately. One spouse may file as head of household if the abandoned spouse requirements are met (e.g., the individual must pay more than one-half of the cost of maintaining a household that is the principal home of a dependent child for more than six months, and the individual must live apart from his or her spouse for the last six months of the year).
Two factors should be considered. One is that the filing of a joint tax return exposes both individuals to joint and several liability for the tax. The IRS Restructuring and Reform Act of 1998, however, provides innocent spouse and separate spouse liability relief. Secondly, head of household tax rates are more favorable than those applicable to married individuals filing separate returns. Additionally, due to the so-called "marriage penalty," it may be desirable to accelerate the termination of the marriage so that the more favorable tax rates applying to single (unmarried) individuals may be used. In contrast, if marital status is found to result in overall tax savings, attempts should be made to delay the divorce until the beginning of the following year.
If divorced individuals file joint tax returns prior to the termination of their marriage, either individual may now elect (under the IRS Restructuring and Reform Act) innocent spouse relief within two years after IRS collection activities begin. The act permits either individual to elect to limit liability to the amount of individual tax deficiency as computed on a separate return basis (IRC section 6015).
In general, divorced individuals face the same issues as married couples in budgeting and overall cash management. However, factors that are unique to divorced individuals include the impact of alimony, property settlement transfers, childcare payments, pre-divorce debt, and tax-related cash flow issues. Since in most states, alimony is determined based upon living expenses and disposable income of each spouse, the data used in the divorce proceedings should be available to the planner. Armed with this information and a schedule of all transfer payments to be paid or received, the planner can assist in the preparation of a budget.
In the case of the payee, the planner should not assume that the payments are sufficient to cover all needs. The amount of alimony to be received could be adjusted in some states based upon marital misconduct, and all expenses that the payee considers necessary may not be reimbursed. Additionally, the award may not take into account such resources as accumulated assets for retirement.
Alimony is typically awarded for a limited amount of time based upon the length of the marriage and will normally end upon death of either party or remarriage of the payee. If alimony payments cease upon the death of the payor, consideration should be given to the need for life insurance. In the case of the payee, the financial planner should also consider the ability of the payor to make all scheduled payments. Perhaps the payor has an uncertain income stream or is in poor health.
The payor's budget should take into account volatility of income with an adequate reserve established to ensure that required payments can be made. If the source of the payor's income is earned income, the disability insurance should be reviewed. In the case of the payor, it is best to be conservative and assume that any contingency that would reduce or eliminate alimony (i.e., the remarriage of the payee spouse) will not occur.
Child support usually terminates at the date the children become emancipated. For both payee and payor, the budget should consider when child support payments end (or change, in the case of multiple children). Certain events may also require adjustments, such as changes in the payor's income. The planner needs to obtain information to determine the circumstances under which child support can be increased or decreased and should assist in monitoring the situation.
The newly divorced individuals will need to establish or maintain their credit. Married couples frequently enter into joint credit agreements (e.g., joint credit cards). If there was only one wage earner, credit is often only in that individual's name. This creates two issues for divorced individuals. While some liabilities such as the house mortgage are transferred pursuant to the divorce agreement, others may have been treated more casually. If the responsible party fails to pay the debt, the other spouse may be held accountable. If possible, joint accounts should be canceled prior to the finalization of the divorce and credit established for each individual.
The second related issue is that if credit is only established in one spouse's name during the marriage, the other spouse may have no credit history and could encounter difficulty borrowing. One solution is to contact credit reporting agencies and request that they list both spouses on accounts for which both were responsible. The spouse with no credit history should apply for easy-to-establish accounts and pay them in full promptly to build a favorable credit history and avoid accumulating nondeductible interest.
Educational Funding and Planning
The divorce agreement normally considers pre-college education as part of the child support payments. Additionally, the party or parties to be responsible for higher education are often specified. The CPA needs to review the agreement to determine this responsibility and ensure the planned funding matches the educational needs of the children and the aspirations of the parents. Most educational planning techniques are the same as those for other individuals. There are, however, some unique aspects.
From a Federal financial aid standpoint, the primary determination of need is based upon the custodial parent. The custodial parent provides 50% or more of the student's financial support for six months or longer during the year. Parents who are separated can also split their income. The custodial parent is not necessarily entitled to claim the student as a dependent for tax purposes. Child support received for all children is included in the determination of Federal aid.
In addition, college financial aid forms require details on the amount and nature of support being provided to any children by both the custodial and noncustodial parent. Both should be encouraged to work together to get the best financial aid package possible. For example, it is unwise to generate a large amount of income (e.g., capital gains) in the year preceding the year for which aid is being requested. If parents have divorced or separated after the filing of financial aid forms, it is critical to notify the educational institution(s) of the changed circumstances promptly and in writing.
Education IRAs should be considered when planning for children's college educations. Although contributions are not deductible, earnings accruing on the IRA are deferred. Contributions to the education IRA are subject to a limitation based upon modified adjusted gross income (IRC section 530). If either spouse has income exceeding the limitation, he or she can make a gift of that amount to the lower income spouse (or to the child) who then can make a qualified contribution to the education IRA.
Hope and Lifetime Learning
Credits. IRC section 25A provides additional incentives through the Hope credit (maximum of $1,500 per child for the first two years) and the lifetime learning education credit (20% of expenses up to $5,000). Subsequent to a divorce, these credits are available only for the taxpayer who claims the child as a dependent. In any given tax year, only one of the Hope or the Lifetime Learning credits or the education IRA distribution exclusion can be elected for each child.
In structuring the divorce agreement, it is important to decide who will retain the dependency exemption once the children begin their post-secondary education. It is necessary to consider the expected income of both spouses, since the Hope and Lifetime Learning credits are phased out for modified AGI between $40,000 to $50,000 for single filers. In order to achieve optimal tax savings, it is advisable to allow the spouse with a lower income to claim the student as a dependent in order to receive the full tax benefits if the other spouse has income beyond the phaseout thresholds.
It is important that insurance needs are evaluated whenever a significant life event occurs. The insurance coverages that will most likely need to be modified as a result of a divorce are life, health, and disability insurance. As noted earlier, adequate life insurance is important if one of the former spouses and the children are dependent upon the other former spouse for support.
Consideration should also be given to the ownership of the policies. While it may seem that the recipient spouse and child would be better off financially if the payor spouse owns the policy and makes the premium payments, the recipients would be the ones harmed if the policy lapsed due to nonpayment of premiums. Another option is to have the spouses own the policies on each other and pay the premiums. A lapse would, therefore, be less likely to occur. Insurance on the life of the custodial spouse should also be reviewed for adequacy.
It is important that both spouses and their children are adequately covered by health insurance. A nonworking spouse and children can usually be covered for up to three years under COBRA through the working spouse's employer.
Other coverage, such as property and professional insurance, is likely to be in force, but should also be reviewed. If ownership in property has changed as a result of the divorce, the insurance policies must be updated to reflect the proper owner and loss-payee.
Each spouse's retirement goals should be examined and weighed against available and prospective retirement savings. The ownership of IRAs and retirement accounts may have been restructured through the use of a qualified domestic relations order as part of the divorce settlement. Alternative retirement funding plans will have to be considered for the period of time a spouse may be unemployed. The availability of social security retirement benefits should also be examined. If both spouses are employed, they will be entitled to social security benefits based upon their own work history. If one has not been employed and will not accumulate sufficient credits in the social security system by retirement, the availability of a divorced spouse's social security benefit should be examined.
The divorced spouse is entitled to a social security spouse's benefit (one-half of the working spouse's benefit), if all of the following conditions are met:
* The working spouse is entitled to a social security retirement benefit,
* The divorced spouse has applied for benefits,
* The divorced spouse is at least age 62 (reduced benefit),
* The divorced spouse is not married, and
* The divorced spouse had been married to the working spouse for at least 10 years.
In some circumstances, the divorced spouse is entitled to benefits even if the working former spouse is not yet receiving benefits.
As with any other client, it is necessary to match the client's risk tolerance, goals and investment time horizon with an appropriate portfolio of assets. Since divorce is a traumatic life event, it can cause a change in the spouses' risk tolerances and, certainly, a change in expected living expenses. The former spouse may be less tolerant of risk and desire safer, lower-yield investments, yet current and future income needs may demand a higher return. Risk tolerance and investment plans should be reviewed at least annually to adjust for changing conditions and attitudes.
As noted earlier, the basis and holding period of property carry over to the recipient spouse after the divorce. If this was not considered as part of the divorce settlement, it is possible that one spouse may have received a "fair" share of property value, but an "unfair" share of marital property tax basis. This may result in taxable gains when the investments are sold. Potential tax consequences should be considered prior to the sale of any property received as part of the divorce settlement.
Wills need revision subsequent to divorce, not only to reflect changes in desired beneficiaries, but also to reflect changes in property ownership. In particular, divorced spouses need to consider whether a guardian is necessary or desirable for minor children should something happen to the custodial parent.
After divorce, the unlimited marital deduction is no longer available; nor is it likely that the divorced individuals will want to bequeath significant assets to their former spouses. They may, however, want to take care of obligations to the children and their former spouses under the divorce agreement. If the divorce has not yet been finalized, the funding of a trust should be considered as part of the agreement, since transfers pursuant to the divorce do not constitute gifts. Alternatively, a cross-purchase of life insurance could be used to cover these obligations.
Any gratuitous transfers other than those required by the divorce agreement are taxable gifts. Further payments to the former spouse or adult child for educational expenses beyond those required by law may also constitute taxable gifts. This treatment can be avoided if the payor makes tuition payments directly to the educational institution. *
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