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Divorce, Taxes, and Retirement Planning

Ed Slott discusses tax and retirement planning considerations amid divorce.

Christine Benz: Hi, I'm Christine Benz for Divorce is stressful enough, but it's also worth bearing in mind the tax and retirement planning considerations. Joining me to share some tips on this front is retirement expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be back here at Morningstar in Chicago.

Benz: It's great to have you here. Let's talk about the new tax laws that went into effect for 2018 that have some repercussions for divorced people. Let's talk about what's going on with alimony and the deductibility of alimony.

Slott: Well, it's no more deductible. This reversed 70 years of tax law. Now, unlike many of the other provisions in the Tax Cuts and Jobs Act, which kicked in in 2018, this one kicks in in 2019. Also, unlike many of the other provisions where they were all temporary--after 2025, they go away, they are eliminated--not this one. This one is permanent. I don't think many people realize that. So, the change is that alimony is no longer deductible to the one who pays it and no more taxable as income to the one who receives it. Now, for many years, like I said, for over 70 years, taxpayers got the benefit of what I call the spread. The spread is this: Obviously, in most cases, I would say, probably just about all cases, the one paying, the spouse who is paying the alimony is probably in a higher tax bracket than the one receiving it. So, if they get the deduction at a higher rate and the one receiving it picks it up as income at a lower rate, that's a spread favorable to that couple. What they did is they reversed the spread and now that spread goes to the benefit of the government.

So, there's a few things you can do. You can't deduct the alimony obviously anymore and the spouse who gets it doesn't have to pick it up as income. But this changes all the negotiations. Now, I've seen things where people are trying to use other assets in lieu of alimony, but the houses, they are finding, aren't working as well. Some of them have big mortgages, sometimes they don't want the house. So, the big asset people are fighting over now or negotiating over, I should say, seems to be a retirement account, because it's for many people their largest single asset, whether it's an IRA, 401(k). So, one suggestion I have is to use that as a negotiating tool in lieu of alimony. Now, it may not work for everybody. But the idea here is--and I'm talking about pretax IRA money--instead, use that. If it's possible, you have to work it through your state law, of course. In lieu of alimony give the other spouse a portion of the pretax IRA. What that does, it puts the spread back in the taxpayer's favor. Because now the person giving part of that IRA or all of it to an ex-spouse is giving away money that's pretax--in other words, money he or she would have had to pay tax on had they withdrawn it. And the spouse gets a retirement account and the spouse when they take the money out picks it up at their lower bracket. So, it brings the spread back.

Now, it doesn't work for everybody. For example, let's say, the spouse receiving it is under 59.5 and they need that money; if they take it out, they are subject to a 10% penalty. So, it may not work for everybody, but it's an idea to put the spread back in the taxpayer's favor using probably one of the biggest assets that they will be negotiating with anyway.

Benz: So, it should be part of the discussion leading up to divorce.

Slott: Oh, definitely. Could help.

Benz: Let's talk about another thing that's a more evergreen problem that can trip up divorced couples or divorcing couples. This is a failure to correctly execute beneficiary designations. Let's talk about how people can run into trouble on that front and discuss some kind of best practices if you are a divorcing spouse and you want to make sure that you are doing this right.

Slott: Well, there's a morass of paperwork in a divorce. You have your financial advisors, your attorneys, the judge, everybody signs a massive amount of papers. But the one thing that seems to almost always be overlooked is updating beneficiary forms on retirement accounts, on life insurance policy, anything beneficiary-driven. So, the big message, the best practices, as you say, is after a divorce, even if you think everybody took care of it--and many people think everybody took care of it... It's likely that you are writing checks to attorneys, to financial advisors, to accountants, you're paying court fees, you go to court. You figured it's all taken care of. You think the accountant took care of it. The accountant thinks the financial advisor took care of it. The financial advisor thinks the attorney took care of it. The attorney thinks the cat took care of it. Nobody took care of it. And it's a big gaping hole.

So, the best practice is, after a divorce, update all your beneficiary forms, so this doesn't get drawn out in court like we've seen Supreme Court cases that lasts for seven or eight years or longer and ends up going--you never know who is going to get the money. Sometimes it goes to the kids of one marriage; sometimes it goes to the ex-spouse. Maybe it's life insurance and that was part of the deal--you still want it to go to the ex-spouse. According to the latest court rulings, even if that's the case, still go in and execute a new beneficiary form naming that ex-spouse if that's what you want. But always execute a new beneficiary form. Update your beneficiary forms after a divorce so people don't have to spend thousands and thousands in money and time to figure out who gets the money. Everybody should know who will get the money right after the divorce.

Benz: And people tend to underrate the power of these... So, would say it's a best practice going through a divorce or not going through a divorce just to review those, say, once yearly as a part of your annual portfolio review, make sure everything is ...

Slott: Always review it, especially when you have, what I call, a life event, a birth, a death, a marriage, a divorce, always after a divorce. That's where we see the biggest problems. You had a new child, a grandchild, a change in the tax law. Best practice is, review them at least once a year. But always, after the divorce is signed, sealed, delivered, go back to the beneficiary forms, especially on 401(k)s, IRAs, and life insurance and annuities--anything beneficiary-driven--and make sure it's the beneficiary that you want. Maybe you want your ex-spouse off or on or you want to make sure it goes to your children in case you get re-married. There's been cases where people thought it was going to their children, but they got re-married. It was a 401(k); it was an ERISA plan, it went to the new spouse and the children were disinherited.

Benz: And how about when I change providers? If I switch from one investment provider to another?

Slott: Definitely. Definitely. Definitely. We just saw a huge case where there was multimillions in an IRA and the financial advisor moved to a new institution and for some reason the new institution changed all the beneficiary forms to the estate when they were supposed to go to trusts and other beneficiaries, and of course, the guy died and now it's a mess--it's a court case and lawsuits and still nobody knows who is getting the money and they may not know for years. So, always update beneficiary forms, especially when your account moves from one institution to another.

Benz: Ed, it's always great to get your perspective. Thank you so much for being here.

Slott: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for