Divorcing at any age can be emotional and overwhelming. The closer you are to your planned retirement age, the less time you have to make changes that ensure a secure financial life after divorce. It is important to know your options before you finalize your divorce. This will help you to make well-informed decisions that will shape your life and financial future.
Financial Planning Considerations
Hopefully, you have already developed a detailed retirement plan with a Certified Financial Planner (CFP®) and your spouse. Now you must understand your entire financial picture as a single person.
There are several questions to address:
- Will I have to change my planned retirement date?
- Can my retirement savings sustain my current lifestyle? If you are not sure, click here to download the Magical Budget Template, and click here to view How to Budget Your Money.
- How will this impact my finances?
- What housing changes will I have to make? These may include downsizing, getting a roommate, or even moving.
- How will my single status change my income tax bracket and health insurance options?
You have many questions about the future. You also face many present decisions that will influence your lifestyle through retirement. Don’t attempt this journey alone. A financial advisor can help you explore all the options before you negotiate a settlement agreement.
Retirement Asset Definitions
Some states consider retirement assets earned during the marriage through the date of separation as community property. These are generally divided 50/50 in a divorce. There are many types of retirement assets, including:
- 401K – employer plans offered by most public and private companies
- Pension – employer-defined benefit plans guaranteed to pay specific monthly benefits through retirement
- 403B – employer plans offered by hospitals and universities
- IRA and Roth IRA – individual retirement accounts established at a brokerage firm or bank
- 457 – employer plans offered by government agencies
- Deferred Contribution Plans, Profit Sharing Plans, Thrift Plans, SEP IRAs, and SIMPLE IRAs
All plans have specific property division rules in a divorce.
This is why it is critical to get assistance from someone who specializes in the area of divorce and retirement.
Divorce and Retirement Plan Insight
An employer-based plan, whether from a current or former employer of you or your spouse, requires a Qualified Domestic Relations Order (QDRO). This is a written authorization for the plan administrator to distribute some or all of the employee’s plan assets to the non-employee spouse.
A QDRO outlines how retirement assets are divided. The plan administrator needs the QDRO and either a divorce decree or a registered marital settlement agreement to transfer assets to the non-employee spouse.
Pensions, commonly referred to as defined benefit plans, require a QDRO plus an additional valuation of the current and future value of the pension benefits. Most pension plans allow the non-employee spouse to take possession of their portion as a lump sum. They may also allow you to continue as a co-annuitant and received future payouts when age eligible.
An IRA held at a brokerage firm does not require a QDRO. However, the division of assets will require a Letter of Instruction plus a divorce decree or a registered marital settlement agreement. Every brokerage firm has slightly different requirements, so it is best to find the protocol before finalizing the divorce.
In community property states, retirement plan assets, earned during the marriage, are considered marital assets and divided 50/50. However, assets accumulated before the date of marriage or after the date of separation are considered the separate property of the account owner and are not eligible for division. This requires tracing separate property interests in these accounts.
It can take time to determine which assets are separate or community property. When assets have been moved, or there are no records of the balances from the date of marriage, it is best to seek the expertise of a financial professional. This may include a CFP®, CDFA®, an accountant, actuary, or Certified Divorce Financial Analyst (CDFA®).
Although transferring retirement accounts between spouses does not trigger taxes, withdrawing from any retirement asset (except ROTH 401k or ROTH IRA) will trigger a tax event. Most retirement asset withdrawals are taxed as ordinary income for the calendar year of the withdrawal.
If you are under 59 ½, the withdrawal will incur a 10% early withdrawal penalty. The one exception is taking a withdrawal within QDRO instructions. The withdrawal must be taken at the same time as the QDRO is executed. Any subsequent withdrawals before age 59 ½ will incur a 10% penalty.
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Health Insurance and Divorce
No one should go without health insurance. However, if you are covered under your spouse’s employer health insurance plan, your coverage will terminate once your divorce is final. You have choices.
- If you are 65 or older, you can sign up for Medicare benefits.
- You can stay on your spouse’s health insurance through a guaranteed program called COBRA. This allows ex-spouses to remain on the same employer plan for 36 months. However, your premiums are no longer subsidized by your spouse’s employer. Currently, you will also pay 102% of the full premium.
- If you are employed, your current employer may offer health insurance benefits. A divorce qualifies as a life event that lets you sign up for your employer’s health insurance plan, even if it is not open enrollment.
- You can also choose an ACA (Affordable Care Act / Obamacare) plan through your state. The premiums may be subsidized based on your income. Your state may require documentation other than tax returns to verify your eligible premiums. ACA plans cannot refuse you based on pre-existing conditions.
- In addition, you may be able to elect a private health insurance plan offered in your state. These usually require an underwriting process, and you may be declined for health reasons. The plan also may not cover certain pre-existing conditions.
- Your financial advisor will help you identify the financial impact of each option and guide you to resources to explore each option in detail.
Social Security and Divorce
Unlike retirement assets which use family law code, court orders, or spousal negotiations to determine the division, the Federal law governs Social Security benefits. Therefore, they cannot be altered.
For marriages ten years or longer, a spouse can collect Social Security benefits based on the larger of their own work record or one-half of the ex-spouse’s full retirement age (FRA). If you remarry, you can receive spousal benefits based on your new spouse but not your ex-spouse. If a spouse dies, an unmarried ex-spouse may be eligible for spousal benefits when reaching age 62 or later.
Unlike Child Support Guidelines, states have not developed a specific mathematical formula for Spousal Support eligibility. Spousal Support can be negotiated by the parties or decided by a family law judge.
A judge will look at many variables, including age, health status, income, separate property assets, ability to work, stay-at-home status, and expenses of both parties. They will also consider other elements of the couple’s situation to determine the amount and length of Spousal Support. There is no guarantee that a judge will award Spousal Support to a lower-earning spouse, especially if the higher-earning spouse is near or in retirement.
In most states, Spousal Support can be categorized as non-modifiable or modifiable. Non-modifiable Spousal Support agreements cannot be changed for any reason. Modifiable Spousal Support allows the courts to maintain jurisdiction over the agreement. In this case, either spouse can ask the courts to review the terms due to a change in financial circumstances, such as a job loss, disability, or new inheritance.
Tax Considerations for Divorce and Retirement
The U.S. tax code determines your filing eligibility based on your marital status on December 31st of the tax year. If you are still married on December 31st, your filing status can be either Married-Filing Joint or Married-Filing Separate. However, if your divorce is finalized by December 31st, your filing status may be Single or Head of Household if you qualify.
Understanding your tax filing status will guide you on whether to take withdrawals from retirement assets, capital gains assets, or cash to cover expenses. Creating a retirement income strategy is a balancing act between managing available income and investments to optimize your tax planning.
Divorce and Retirement Equalization
Community property or marital assets are eligible to be divided 50/50. You can accomplish this by adding up assets titled in each spouse’s name and then determining an equalization payment.
For instance, let’s say that one spouse owns $700,000 in retirement assets and the other spouse owns $500,000. Then the spouse with the higher balance will transfer $100,000 as an equalization pursuant to the divorce so that both have $600,000.
Not all assets need to be divided like-for-like. For instance, one spouse may elect to waive rights to retirement or investment accounts in exchange for an equal amount in home equity. This may serve both spouses if one prefers to keep the family home and the other prefers the liquid assets.
And while this works on paper, there are many considerations for these exchanges. Real estate is a viable net-worth asset and a place to live. But it is not a liquid asset. Be sure to consider your ability to maintain mortgage and maintenance costs going forward, especially if you are on a fixed retirement income.
Assets such as retirement accounts, pensions, and some annuities are funded with pre-taxed dollars and treated as ordinary income. Real estate and stock brokerage accounts are capital gains assets that usually enjoy a lower tax effect than ordinary income sources. When negotiating equalization of non-like-for-like assets, consider the after-tax value.
Summary – Divorce and Retirement
There are many considerations during a divorce. And, it is often one of the most overwhelming times of your life. Besides the emotional stress, you must make life-changing decisions that impact your finances and life. As you approach retirement, the consequences may be amplified by the lack of time to make significant changes that determine your long-term financial situation.
You do not have to tackle this alone. Building a team of competent and compassionate professionals will help ease the stress and empower you to make the best decisions for you and your family.
A Certified Financial Planner (CFP®) or Certified Divorce Financial Analyst (CDFA®) can model scenarios to consider your divorce settlement’s short- and long-term financial impact. These professionals are well-versed in the issues of divorce and retirement and can help you realize the best outcome for your situation.
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