6 MIN ARTICLE
When a divorce settlement is reached or judgment entered, both parties often feel their work is done. But there can still be a lot left to do to see the terms of the settlement or court order fulfilled and the client's new situation reflected in their financial and estate plan and lifestyle.
As an financial professional, you can help clients by raising important and time-sensitive considerations to discuss with an estate planning attorney or tax professional. The answers to the following questions can help guide newly divorced clients through estate planning essentials.
What happens to an estate plan after divorce?
While it's generally true that estate planning documents remain in effect after a divorce, they no longer operate in the same way. In many states, the provisions of a will or living trust that benefit or give authority to a spouse are no longer effective upon divorce or even a legal separation.
In certain states, an ex-spouse is considered deceased where the estate plan documents are concerned. This means an ex-spouse named as beneficiary to the assets upon the death will be overlooked, and the assets pass to the next beneficiary in line. Designed to protect the recently divorced who die before updating an estate plan, both parties need to be aware of these laws and plan accordingly.
Should you update estate plans after a divorce?
Absolutely. Estate planning attorneys recommend reviewing estate plans after any big life event. Your client’s divorce settlement may require certain bequests upon death, which are documented in the will or living trust.
Before meeting with an estate planner, here are some things a client should consider:
- What are the guardian provisions?
If minor children are involved, who will be the guardian if both your client and her ex-spouse die? If your current choice is a family member or close friend of one spouse in particular, it may be worth discussing an alternative.
When it comes to the kids, it's best to know the divorced couple is on the same page regarding successor guardians. If she appoints her sister and he appoints his brother, it's the court that has to choose between the two — and there's a risk of the decision being neither. In any case, it will only result in conflict and uncertainty for the children at a challenging time.
- Who is the executor or trustee?
Who should be named as executor or successor trustee? The answer is subjective, depending on the relationship between the divorced couple and other family dynamics.
Naming an executor or trustee comes down to choosing who will manage and dispose of your client's assets when she dies. If her only beneficiaries are her children with her ex-spouse and their interests as parents are aligned, she may prefer the ex-spouse serve as the fiduciary. If the children are minors, distributions from the trust may go to the ex-spouse acting in the role of the children's guardian.
In a nasty divorce, your client may consider naming someone else close to the children. In some cases, a corporate trustee may be a wise option.
- Is there an irrevocable trust?
Irrevocable trusts generally cannot be changed or nullified. However, many irrevocable trusts include provisions that allow certain changes. Some state laws provide similar flexibility.
An estate planning attorney can help your client understand how any trusts created during the marriage can be modified. Even if you covered this in the divorce negotiations, these types of trusts typically don't "belong to" either spouse and are sometimes overlooked.
If the client had an irrevocable trust during the marriage, the questions are similar: Should there be a change to the trustee or successor trustee? Can any distributions be adjusted to reflect changes in the family's financial situation after a divorce? And will there be conflict over other trust provisions down the road?
- Are beneficiary designations in place?
Everyone should regularly check in or update the beneficiary designations for retirement accounts and life insurance policies. But after a divorce, beneficiary designations are particularly important.
Unfortunately, many state laws that automatically revoke an ex-spouse's interest under a will or a living trust upon divorce don't operate the same way with beneficiary designations. That means if your client dies after a divorce but before updating her 401(k) beneficiaries, the ex-spouse could walk away with the savings.
Before changing beneficiary designations to the children, help your client understand the impact of the SECURE Act on inherited individual retirement accounts (IRAs). With the elimination of the "stretch" inherited IRA for most beneficiaries other than spouses, your client may want to consider researching alternative planning arrangements or donating her retirement assets to charity.
Are there other tax considerations for the recently divorced?
In 2005, the lifetime exemption from estate taxes was $1.5 million. Today, it's more than $13 million,* which means relatively few clients will need to worry about paying an estate tax. But this may change once the current law sunsets in 2025. Additionally, there will be income tax changes to consider in the meantime. Wherever your client stands today, here's how taxes may change:
Gift and estate taxes: Under the unlimited marital deduction, in a typical marital estate plan, gift or estate taxes might not need to be paid until the death of the second spouse. But if your client is no longer the primary beneficiary of the assets upon her ex-spouse’s death, she no longer gets the benefit of that deduction. That's why clients with substantial assets should talk to an estate planning attorney about how to mitigate potential liability. Cash may also be a concern if estate taxes are due, so it's essential to maintain a pool of liquid assets to satisfy any liabilities.
Income taxes: Filing as a single person, rather than jointly with a spouse, may result in a substantial change to a client's annual income tax bill, for better or worse. Either way, your client should work with a certified public accountant (CPA) to understand post-divorce income tax projections.
Alimony: Taxes and alimony get tricky depending on the timing of the divorce. For divorces finalized in 2019 or after, at the federal level, alimony payments are not deductible by the paying spouse and are not considered income of the recipient spouse. For divorces finalized in 2018 or before, the opposite is true: The paying spouse can take a deduction, and the recipient reflects the payment as income on their return.
State tax law around the tax treatment of alimony varies. In certain states, the federal pre-2019 deductibility still stands. Clients should consult with a CPA who is well versed in the tax laws in their home states.
Child support: Child support payments cannot be deducted from the payer’s income taxes and are not considered income to the recipient.
Though clients nearing the end of a divorce may not be thrilled at the prospect of more to-do’s, they'll appreciate your support. Help your client schedule a meeting soon after the settlement to address time-sensitive items without delay. By discussing the considerations described above, you can help her turn the page and begin a new chapter with confidence.
Take action: Three things to do when finalizing a divorce
You can use our Finalizing a divorce: Discussion checklist to help assess the needs of your clients. In the meantime, here are a three essential steps to consider.
1. Complete asset transfers
All property transfers required under a divorce agreement or judicial decree should occur as soon as possible. Why? Although there should be no gift or income tax consequences from transferring assets in a divorce settlement, this preferential tax treatment could be compromised if the transfer takes too long. Depending on the state of residency, the court may prevent the transfer of assets until after finalizing the divorce. Transfers should happen once the court lifts these restrictions.
Assets with a formal title — like real estate, bank and investment accounts, and entity interests — require a title transfer to the new owner. For example, if the couple owned the family home jointly when married, but it goes to your client under the divorce agreement, it should be retitled.
2. Get a QDRO for retirement accounts
Courts often divide retirement account assets in a divorce. Because of the special rules around federal retirement benefits, it is not sufficient to divide a pension plan or 401(k) under a divorce agreement. Instead, the judge issues a separate order — a qualified domestic relations order (QDRO) — requiring the retirement plan administrator to grant a portion of the benefits to the employee's former spouse. Because of the administrator's involvement, precision counts in drafting that part of the divorce settlement agreement and the accompanying QDRO.
Your client or her divorce attorney may want to consult a local attorney specializing in QDROs before finalizing the divorce settlement. In certain states, attorneys might not always issue a QDRO in conjunction with the divorce settlement. Confirm your client obtains QDROs for all of the former couple's federal retirement assets.
3. Be aware of at-death obligations
If the divorce agreement requires your client to make bequests in her will or living trust upon death, she'll need to make these updates with an estate planning attorney. If similar obligations apply to the ex-spouse, it can make sense for the two ex-spouses' estate planning attorneys to work together to see that the obligations are satisfied and updated in plan documents.