Divorce results in the division of a household’s assets and income, but parties involved should consider that sometimes a split that appears equitable may not be.
Some assets, whether securities or real estate, may have large unrealized capital gains or deferred income tax that could diminish their after-tax value. A risk-averse spouse may end up with assets that have limited liquidity, or a high risk profile. Spousal support and child support may or may not keep up with the rising costs of living, and may not be protected in the event that the higher-earning spouse no longer has the ability to generate income.
For these reasons and more, couples considering a separation need to review all of their assets and income needs in the context of their overall financial and tax picture.
Consider the tax status of all assets to be divided between spouses.
What are the unrealized capital gains for the taxable assets? What are the income-tax implications for each spouse, given his or her income level, of the tax-deferred or tax-free retirement assets, such as 401(k)s or IRAs? For a spouse who needs to draw on investments in the near term, will he or she be able to access the assets in a retirement account without early-withdrawal penalties? Will the division of assets ensure that no one spouse is saddled with a disproportionate share of tax to pay?
When one spouse agrees to keep the primary residence as part of his or her distribution of marital assets, he or she may be unwittingly sacrificing financially for the comfort of remaining in a meaningful home.
A home is less liquid than marketable securities in an investment account; it’s difficult to predict how long it might take to sell real estate, and at what price. A portfolio requires no repairs or maintenance, but a home needs upkeep, the cost of which could place a strain on the cash flow of the spouse who remains. And like investment assets, a home could carry an unrealized gain that could create a significant tax bill upon its sale.
A couple selling a home may be able to qualify for a capital gain exclusion of $500K if they’ve both lived in the home for two of the last five years. But, as time passes and only one of the former spouses meets the residency requirement, the capital-gain exclusion will be halved to $250K.
Any household is likely to own investments that vary in risk. There may be assets in the marital estate that do not reflect the preferences and goals of both spouses, especially in cases in which one spouse is uninvolved in the household’s investment decisions.
Assets should be reviewed in detail, in an effort to avoid a situation in which a spouse with a modest risk tolerance and limited investment knowledge ends up with, say, a portfolio of highly appreciated internet-company stocks, or an illiquid investment with high risk and little transparency.
The details of alimony and child-support payments in the divorce documents could create payments that will fall short of needs in time, even if they cover current costs. An equitable agreement should include adjustments for inflation on support payments so that they keep pace with costs, particularly faster-growing costs in categories like medical and education.
Support payments based on a percentage of the higher-earning spouse’s income could be beneficial for the lower-earning spouse; when combined with a dollar-value minimum payment amount, this strategy could offer the lower-earning spouse both downside protection and a chance to capture the upside of the higher-earning spouse’s future income.
Also worth noting is that the Tax Cuts and Jobs Act made a significant change to the taxation of alimony affecting divorces filed after 2018: Alimony will no longer be taxable to the recipient, nor tax-deductible for the spouse making the payments.
The higher-earning spouse might only be able to make alimony and child support payments if he or she has income. To help protect the lower-earning spouse and children, the divorce documents should include a requirement that the higher-earning spouse maintain life insurance and long-term disability insurance for the term of the support obligation. The benefit amounts should be calculated to meet the needs of the lower-earning spouse and children.
If a couple has a capital-loss carryforward amount on their joint tax return, this should be reviewed to determine how the amount will be allocated between spouses. A cap-loss carryforward can be used to offset capital gains that may be realized if a spouse wants to sell appreciated assets following the divorce, giving it special importance in a divorce.
Generally the capital loss is divided according to which spouse’s assets incurred the loss. However, if the loss resulted from the disposition of jointly owned property, the carryforward amount is divided equally. In some states, the treatment of the carryforward amount is subject to negotiation in the division of assets, so there may be an opportunity to match the carryforward amount with assets with offsetting unrealized gains.
These are just a few of the factors that should be considered before beginning the division of assets in a divorce. Of key importance is reviewing all assets in detail and in the context of each spouse’s total financial picture, and it’s recommended that you do so with your financial advisor. With forethought and planning, a divorce agreement can be fair and favorable, allowing the separating spouses to begin the next chapters of their lives with the confidence that they have arrived at a positive resolution.
Could you benefit from working with a financial advisor while dividing your assets as part of your divorce agreement? Schedule a complimentary consultation with a member of our team today.