Is Divorce Planning a Prudent Strategy for Both Parties?
While it might sound sinister, divorce planning is actually a legitimate technique in many cases. Divorce planning does not mean hiding assets or reducing income to avoid financial obligations. In my book, Frumkes & Vertz on Divorce Taxation, we discuss some of the predominant strategies: shifting income to a lower tax bracket (in order to make more net income available); accomplishing divorce-related property transfers without triggering tax; and getting a handle on business valuation and incentive compensation plans that may come into play. Divorce planning may be a prudent strategy for both routine and high net-worth cases.
Shifting Income to a Lower Tax Bracket
In many cases, one spouse earns more – and is in a higher tax bracket than – the other spouse. The difference is stark in cases involving a stay-at-home parent who has little or no income. Many times, the family can reduce the combined tax liability by shifting taxable income from the high-earner’s tax return to the low-earner’s tax return. This income-shifting is the primary benefit of alimony and spousal support.
To some people, alimony is a dirty word. But realistically, it can be used as an effective tool to reduce taxes and make more net income available. In many cases, the tax savings can benefit both spouses and their children. Alimony can be paid on a temporary basis, to ease the family’s cash flow during the divorce negotiation period, or it can smooth the financial transition that occurs when the divorce is final. Income-shifting and tax reduction are some of the tools we use for divorce planning.
Avoiding Tax in Divorce-Related Property Transfers
Some forms of property, like retirement accounts, investments or a business, can have hidden tax liabilities. If those tax liabilities are shifted into a lower tax bracket, by transferring property from one spouse to another, it can be a win-win for both spouses. This strategy requires a good eye for spotting and estimating the hidden tax liability, and conscious planning to shift the tax into a lower tax bracket. Similarly, spouses should consider the tax-deferred characteristics of retirement accounts, which allow them to grow at a faster rate than many other assets.
Splitting retirement accounts is an opportunity for tax savings, or a disaster if it is not handled right. For instance, many 401K-type retirement accounts permit a spouse to take a one-time lump sum distribution in cash that is exempt from the 10% early-withdrawal surtax. (Even so, the lump sum distribution is subject to regular income tax.) If the transfer is handled improperly, however, the 10% surtax will be triggered. The spouse who is receiving a lump sum distribution from a 401K-type plan (known as the “alternate payee”) cannot deposit it into an IRA account before making a withdrawal. Doing so will trigger the 10% penalty.
Also, some financial institutions demand a qualified domestic relations order to split an IRA, even though the federal law, ERISA, does not apply to IRA accounts. This leads some people to think they can avoid the 10% surtax when splitting an IRA account. They can’t; the penalty applies unless the alternate payee is age 59-1/2 or older.
Understanding Business Valuation and Executive Compensation on Divorce
As a matter of divorce planning, it is prudent to investigate and understand the contours of business valuation and executive compensation plans before the game is on. A business owner might want to get a handle on what the business is worth, and how to pay a “buy out” upon divorce. Likewise, a divorce lawyer can learn a lot by reading the terms of a client’s incentive compensation plan (which may include bonuses, stock options, restricted stock, SARs, ISOs, etc.) to determine whether they might be treated as income or marital property.
Divorce planning is not taboo if it means anticipating the financial impact of a divorce and making plans. Estranged spouses should consider how a divorce might affect their income and expenses, and how they might adjust spending and saving. Divorce planning can help to anticipate and resolve issues that might arise in a more contentious fashion during the heat of litigation.
Brian C. Vertz has represented all kinds of people with complicated child support and divorce issues. His law firm is a powerful team of lawyers dedicated to family law. In Pittsburgh and Western Pennsylvania, call Brian at 412-471-9000.