Contributed by: Jacki Roessler, CDFA®
Are divorcing couples more susceptible to becoming sick with a virus than the rest of us? According to the Holmes and Rahe Stress Scale[1], a research study that measured the correlation between stressful life events and future illness, divorce is second only to the death of a spouse as a predictor of future health problems. Viewed through the lens of our current social, health and economic environment, this insight resonates particularly strong. As I write this in early April 2020, Family Courts around the Country remain closed (other than for essential emergency matters), however, several divorce-related issues can’t wait. There are also some unique planning opportunities offered through the newly passed CARES (Coronavirus Aid, Relief and Economic Security) Act that may be appealing to divorce clients.
First Things First: Cash Flow Needs
One of the most important (and revealing) questions to ask clients right now is “how are you managing with your cash flow?” For those who are dependent on temporary support to pay their bills, this is a good time to discuss cash flow priorities and make sure there haven’t been any changes to the status quo. For some that may mean re-directing outflows to expenses that take the highest priority such as food, mortgage payments, and utilities. For example, take a hypothetical client Anne...I had a virtual meeting with my client and her attorney. Anne revealed she was feeling panicked about her dwindling cash reserves. Concerned about her mounting legal fees, she had been using her temporary support to make payments to her lawyer. Anne’s attorney let her know their firm was suspending the accrual of interest charges on outstanding legal fees during the current crisis. She also directed her to pay legal fees from a joint marital account and use her income for her family’s living expenses. Similarly, now is not a good time for clients to add to their credit card balances. Discretionary spending for most clients should be reduced or eliminated if at all possible during this time of economic uncertainty.
For clients who are concerned about low liquidity in their estate, they may want to discuss liquidating securities or mutual funds in post-tax brokerage accounts to free up cash. Although it’s never the best idea to sell into a down market, in certain cases, it may be necessary. Clients should be advised to consult with their financial and/or tax advisor to determine the most tax advantageous way to liquidate securities while taking their overall long-term investment strategy and financial goals into consideration.
Other clients may not have any brokerage accounts to liquidate despite their concerns about short term cash needs. In fact, for the vast majority of my current open divorce cases, the parties have the bulk of their assets tied up in retirement accounts and real estate equity; neither of which can be easily accessible for cash needs. There are two provisions of the newly passed CARES Act that may help clients who are looking for creative ways to free up cash.
CARES Act changes to 401(k) loan rules
Before the passage of the CARES Act in March 2020, federal law provided a means for employees to access the money in their retirement accounts for short term personal loans. Qualified plan sponsors could allow employees to borrow up to $50,000 or 50% of their total account value (whichever was less). The benefit of a 401k loan is that it can be quickly and easily accessed, there aren’t any long approval delays and the borrower pays the money back to him or herself. Loans aren’t treated as taxable distributions and the employee immediately starts to pay the loan back through (after-tax) payroll deductions.
The CARES Act expanded the existing program by increasing the loan limit to $100,000 or 100% of the account balance (whichever is less). This may be a valuable tool for divorcing clients to access money during the divorce, as long as both parties understand the money must be repaid. This opportunity is time-sensitive as the increased limit is only available through September 22, 2020.
There are other pitfalls to parties taking out loans that attorneys and financial professionals should discuss with their clients. Let’s suppose, for example, Jane and Jack are in the process of divorce. Jack is feeling anxious about his job as his employer is considering potential layoffs. Without conferring with his attorney, Jack initiates a loan of 100% of his 401(k) balance to pay his temporary spousal and child support to Jane. Jane’s signature isn’t required for the loan and he takes it without her knowledge or agreement. Will this loan be considered dissipation of the marital estate, a separate debt of Jack’s alone or will it be viewed as a legitimate marital debt the parties will share? It’s certainly something he needs to discuss with his attorney before he takes any action.
Even if the parties agree that a 401k loan is a good idea for both of them in the short term, Jack needs to understand the potential risks. If his employer is forced to lay him off, for example, the loan would need to be repaid within the tax year it is withdrawn. If it isn’t repaid, it's treated as taxable income and Jack would also owe an additional 10% penalty for early withdrawal since he’s under 59 ½ years old.
CRD-Coronavirus Retirement Distributions
The other option the CARES Act provides is a CRD (Coronavirus Retirement Distribution) for those who have the virus, have a spouse or dependent with the virus, or those who experienced financial hardship due to the virus. As of now, it seems that what qualifies as a “financial hardship” will be loosely interpreted and monitored. The maximum withdrawal amount is $100,000 per person and can be from an IRA, 401k, 403b, or other qualified retirement annuities as long as the plan sponsor allows it. Additionally, taxes on the withdrawal can be spread out over 3 years and will not be subject to the 10% penalty for early (pre age 59 ½) withdrawals.
For many divorcing couples, this might provide a planning opportunity to free up liquid assets within the marital estate. It’s important to note that to qualify, distributions must be made before December 31, 2020. Liquid assets may be needed for one or both parties for their cash reserves, to pay legal fees, moving costs or other one-time expenses. They also may be needed to buy-out all or a portion of alimony in certain cases.
One important note for couples who will be filing separately in 2020 is that any distribution will be treated as taxable income to the person who withdraws the money. For example, suppose Jack and Jane want to free up $75,000 in cash from their combined retirement accounts. Although they both have separate retirement accounts, they decide it makes sense to take a $75,000 CRD from Jane’s IRA. They plan to split the net proceeds between them and they want to minimize taxes. Jane who plans to file as Head of Household in 2020 and whose sole income will be child support and alimony will be in a low tax bracket for the next several years. Jack predicts he’ll be in a high tax bracket. Jane will spread the tax liability on the distribution out over 3 years, thereby greatly minimizing (possibly even eliminating) the tax liability on the distribution.
Although the tax liability can be spread out over 3 years, it’s still important to note that it’s best to leave retirement assets invested in tax-deferred vehicles, if at all possible. Of course, Jane and Jack should also be advised to consult with a qualified tax advisor about their particular situation before taking any distributions.
In stressful times such as these, it’s easy to forget that the new world we’re living in may provide unique planning opportunities. Now, more than ever, divorcing clients need the professionals they work with to reach out to them with creative ideas, suggestions, and re-assurance.
[1] Holmes and Rahe (1967) – used a self-report measure with their Social Readjustment Rating Scale (SRRS) which looked at the events which had occurred in a person's life and rates their impact.
Jacki Roessler, CDFA®, is a Divorce Planner at Center for Financial Planning, Inc.® and Branch Associate, Raymond James Financial Services. With more than 25 years of experience in the field, she is a recognized leader in the area of Divorce Financial Planning.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the author and not necessarily those of Raymond James. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Examples used are for illustrative purposes only.