Jacqueline B. Gold, CDFA
Center for Financial Planning, Inc. (Southfield)
It had been a challenging year. After fighting over spousal support, child custody and the marital estate, it was time for the clients to breathe a sigh of relief as signatures were placed on the final divorce decree. This unpleasant life chapter was now over, and the divorced parties could turn to a new clean page, leaving all things divorce-related behind them. Or could they?
While many divorces end quite neatly, the large majority of couples have various post-divorce lingering issues to attend to. Some of those issues are uncomplicated and fairly painless to address, whereas others can become extremely complex and muddled. In fact, for many couples, the post-divorce years contain many financial items to tie up, including the transfer of assets between the parties as well as current and future estate and financial planning issues. This article will provide some insight into the most commonly experienced post-divorce financial "loose ends" as well as suggest simple ways to avoid them.
Smooth Transfer of the Marital Home
Jane got the house. It wasn't easy either. John wanted the house sold and the proceeds split to provide both he and Jane with some much-needed liquid cash. Finally, John relented and told Jane the house was all here-provided that she re-finance the mortgage into her own name within sixty (60) days from the date of divorce. He had doubts about how Jane would be able to qualify for the mortgage on her own and also doubted she could afford the $1,600 per month mortgage payment - not including the taxes, insurance, utilities and maintenance costs. In fact, the divorce decree stated that if the house was not re-financed within sixty days it would be immediately placed on the market for sale.
Jane on the other hand, wasn't worried at all. After she left her attorney's office, she drove straight over to her bank to start the re- finance paperwork. Unfortunately, Jane was beginning to understand that things were not quite over as the unsympathetic banker shook his head and told her he doubted she'd be able to qualify for a conforming loan. He would have to place her in a non-conforming loan, which would have a higher intrinsic cost and interest rate. In fact, Jane's $1,600 per month principal and interest payment would increase to a whopping $2,300 per month.
The reasons were two-fold. First, Jane had no earned income to report, even though she would be receiving $42,000 per year in spousal support and an additional $35,000 in child support. In addition, her credit scores were low due to late payments on credit cards held joint with John as well as 12 months worth of late car loan payments (the loan was in her name). She explained that according to her divorce decree - John was supposed to assume all credit card debt (holding her harmless) and that there was a Temporary Order on file with the court, which stated he had been required to maintain the status quo. The banker wasn't impressed by these explanations. He told Jane that divorce decrees and orders with the State Court were not binding on third parties, such as credit card issuers and banks. In other words, if a loan in Jane's name reported 12 months worth of late payments, it would damage her credit regardless of what her divorce decree stated. In turn, mortgage lenders are concerned with credit reports, not divorce decrees, when it comes to existing debt and late payments.
This is a common post-divorce occurrence. It's imperative that the low wage-earning spouse gets pre-approved for a mortgage before offering to re-finance the loan into his/her own name. Lenders are adopting more stringent requirements relating to spousal and child support. In fact, in today's low interest rate environment, even the most lenient lenders are requiring a minimum of a three-month history of payments and many more are requiring a one-year history. This can be a significant problem for the spouse who has agreed to re-finance the loan within 60 to 90 days.
In fact, each party to a divorce should discuss their credit history with their mortgage specialist, while the divorce is still pending1. Reviewing a credit report could pre-empt three potential problems. First, it allows the person whose credit is damaged by the other party to bring that fact into settlement negotiations. For example, if Jane's attorney had seen her credit report, perhaps she would have requested a monetary settlement for the damage done to Jane's credit. Second, Jane might have an opportunity to clean up her credit report by writing letters to credit reporting agencies and submitting copies of court orders. Third and most important of all, everyone (including Jane) would have a clear understanding of the difficulty involved with Jane immediately re-financing the mortgage into her name.
Other options to consider would be agreeing to re-finance after one year of spousal and child support payments or perhaps Jane could do some legwork on obtaining a cosigner for the loan. The bottom line is that investigations into the feasibility of obtaining a new mortgage need to be done before the judgment is entered to avoid unnecessary stress, and potential future attorney costs for the parties.
Beneficiary Designations
Life Insurance Contracts
Attorneys do a great job explaining to their clients that they should change the beneficiary designation on retirement accounts, life insurance contracts and employer sponsored pension plans. The problem is that the frazzled client sitting at the attorney's desk who is nodding along distractedly may not have actually heard the meaning behind the words. Sometimes, a "horror story" goes a long way to impress upon clients why it's important to complete this post-divorce paperwork change.
For example, let's take the case of Bill and Sarah. Bill drove away from the courthouse with his True Copy of the Divorce Decree clutched in his hand. He then proceeded to toss it in his trunk, underneath his gym bag and a few old magazines. His attorney told him to change the beneficiary designation on his life insurance policy that currently named Sarah as beneficiary to $1,000,000 of death benefits. Sarah was not receiving spousal support nor did the parties have any minor children on whom child support was being paid. Bill called his life insurance agent who, in turn, never sent Bill the beneficiary change paperwork.
Two months later. Bill got remarried to Karen. Fast forward another three years later, and Bill and Karen (a stay-at-home mom) had welcomed two children into their family. In the middle of his morning jog, Bill had a sudden heart attack and died on the spot. Karen was distraught but wasn't concerned about her finances since she knew that Bill had a million dollar life insurance policy that would allow her and the children to maintain their current lifestyle. Unfortunately for Karen, Bill had never removed Sarah (his former spouse) as beneficiary from the policy and funds were distributed to her instead of Karen.
Clients need to understand that if their ex-spouse was their beneficiary and the designation is not changed, their former spouse may receive the proceeds upon their death.
Of course, the flip side of this scenario would be if Bill and Sarah had children together and Bill was still paying child support at the time he died. If he had changed the beneficiary designation on the life insurance policy, without Sarah's knowledge, regardless of the fact that his divorce decree mandated he name Sarah as beneficiary to the extent of any remaining child support owed, she would not receive any life insurance proceeds. Of course, Sarah could sue Bill's estate, but what if she needed the money immediately to continue her mortgage payments?
The easy solution to this problem is make Sarah the owner of the policy (in addition to the beneficiary). The insurance carrier always notifies the owner if premium payments aren't being made in a timely manner and only the owner can change a beneficiary on a contract. Another simple remedy would be to insert a clause in the judgment granting Sarah a lien against other assets in the estate if Bill were to remove her as beneficiary of life insurance securing support. Clients should discuss all alternatives with their divorce attorney to obtain advice that is based on the particular circumstances of their case.
Retirement Accounts and Employer Sponsored Pension Plans
Beneficiary designations on retirement accounts and employer sponsored pension plans that are covered under ERISA (Employee Retirement Income Security Act of 1974, as amended) also have strict rules regarding beneficiary designations. Those rules have been upheld by the U.S. Supreme Court in the case of Boggs v Boggs. (96-97), 520 US 833 (1997), and more recently Egelhoff v Egelhoff (99-1529) 532 US 141 (2001). Both cased opined that ERISA (the Employee Retirement Income Security Act of 1974, as amended) pre-empts orders of the state court2 In other words, if a divorce decree states that a party is to receive their pension "free and clear" of any claim by that party's former spouse and yet the owning spouse never changes the beneficiary designation, ERISA mandates that the beneficiary designation will hold. It stands to reason that this same rule could be applied to non-qualified plans such as IRA's and non-qualified annuities.
Let us return to Bill and Sarah for another example. Sarah had a Rollover IRA account, held at XYZ fund company. This was an account she brought into the marriage and had never contributed to during the marriage. Her designated beneficiary was Bill. After their divorce, Sarah never changed her beneficiary designation on the account. If she were to pre-decease Bill, the money would not go to her desired beneficiary (her mother), but would be paid out by XYZ fund company to Bill. Taking this example one terrible step further, if Bill were to subsequently die, his new wife Karen (versus Sarah's mother) could end up with Sarah's IRA money. Sarah's estate might have a claim against the funds, but consider the financial cost and emotional turmoil involved with filing such a suit.
Domestic Relations Orders
This brings us to the next (and perhaps most significant) potential post-divorce financial problem. An entire book could be written (and many already have) about problems with dividing up employer sponsored retirement plans. Employees are often participants in defined contribution (i.e. 401(k)s) retirement plans and/or a defined benefit plan. A defined contribution plan is one in which an employee (and/or employer) put money into an account on a pre-tax (and sometime post-tax) basis. The money grown income tax deferred until it is withdrawn at retirement. A defined benefit plan is the type of plan where the employer promises to remit monthly payments to the employee upon retirement for the rest of his/her life. In order for an ex-spouse to receive a portion of either type of "qualified"3 plan, a separate legal document is needed in addition to the Judgment of Divorce. This document is called a Qualified Domestic Relations Order (or QDRO for short).
In an ideal, perfect world, all QDRO's (Qualified Domestic Relations Orders) would be entered simultaneous with the Judgment of Divorce. However, it is often not feasible and unrealistic for that to occur, due to timing and other considerations. Pursuant to the Retirement Equity Act of 1984 (REA), which amended the anti-circumvention clauses in ERISA (Employee Retirement Income Security Act of 1974, as amended), qualified plan assets can be assigned to an alternate payee who is a spouse, former spouse, dependant or child of the plan participant (IRS Code Section 414(p)), without "alienating" the plan and thereby obliterating the plan's qualified status, under the Internal Revenue Service. However, in order to accomplish this, a Qualified Domestic Relations Order, signed by a state court judge, must be submitted to the plan and approved by the plan administrator.
It's important to note that Congress granted plan administrators sole authority in determining whether or not an Order is indeed qualified under ERISA and plan specific requirements. This also means that until a QDRO is approved by the plan, the alternate payee has no rights under the plan as a beneficiary.
Events that could trigger the limitation or exclusion of an alternate payee's interest in receiving plan benefits include the retirement or death of the participant prior to approval of the QDRO. Since timing can be critical, all QDROs should be submitted to the court either at the same time the judgment is entered or soon thereafter. Not only does this alleviate post-divorce QDRO language disputes, but it also is the only action that will truly protect the interest of the alternate payee in plan assets.
It's also important to remember that certain State, and local plans (which are not qualified under ERISA and therefore are subject to the State's Eligible Domestic Relations Order (EDRO) rules instead), do not allow an assignment of an interest to a former spouse when the participant is in pay status. A combination of spousal support and life insurance may be necessary in these types of situations to secure the former spouse's interest.
Other important items to remember are Michigan specific rules. If the QDROs are not entered at the same time as the judgment, it's extremely important to include detailed QDRO language in the judgment For example, as was demonstrated in the case of Quade v Quade, 238 Mich App 222, 604 NW2d 778 (1999), any benefits not expressly in the judgment of divorce should not be included in the QDRO, such as early retirement subsidies. An early retirement subsidy is an extra monthly payment provided to the employee as an incentive to retire early and usually will terminate upon the attainment of the employee's eligibility for Social Security benefits. This case followed the precedent set by Roth v Roth, 201 Mich App 563, 569, 506 NW2d 900 (1993) in which survivor benefits under the plan were viewed as a separate and distinct component from the pension benefits. Since they were not included in the Judgment of Divorce, the court ruled that the alternate payee was not entitled to receive any. Sometimes, the solution to this problem is to involve a QDRO expert in the case to review the Judgment language, priortoentry with the court.
Keep in mind that IRA's are not qualified plans and thus, technically should not require a QDRO for transfer pursuant to a divorce. IRA's can typically be transferred from one spouse to the other (as a non-taxable event pursuant to IRS Code 408(d)) with a copy of the divorce decree and a letter of instruction signed by the account owner. It is important to investigate with account custodians what paperwork will be required to effectuate the transfer, before the divorce is final. Remember, as time passes, post-judgment, it can become difficult to get the other party to sign forms and write letters in a timely manner.
Estate Planning Documents
It goes without saying that major life changes, including divorce, require a change in a person's estate plan. Wills and trust paperwork need to be updated and perhaps revised. it's important to remember to retitle assets into the name of the new trust. Many people (whether divorced or married), create trusts and then overlook the crucial step of retitling assets into the name of the trust, which renders the trust fairly useless.
Durable Powers of Attorney need to be amended or created if they are not already in place. Put simply, a Durable Power of Attorney is a legal document that grants another party the right to make legal and financial decisions in the case of incapacitation. Married people often depend upon their spouse to take over in the event they need (either temporarily or on a permanent basis) someone else to deal with financial and legal decisions and activities (such as bill paying). As a single person, it's important to ensure there is a trusted person who will be counted on to perform those types of functions, if needed. Medical Powers of Attorney can also be executed, which assign someone to make medical decisions if they are required.
An often-overlooked issue is to have parents of divorcing couples review and update their own estate plan documents. For example, suppose that in the case of Jane and John, Jane's mother hadn't addressed her own estate-planning as it related to her former son-in-law. As the reader may recall, John and Jane had a highly contentious divorce - they were not friends when the dust settled. Now let's suppose that Jane's mother (for the sake of convenience) had added John and Jane as joint owners on her home. Let's also suppose that she forgot to remove John's name prior to her death. Upon Jane's mother's death, who does her home go to? Unfortunately, John and Jane now jointly own Jane's mother's house. Even scarier, what if John declared bankruptcy and creditors attached Jane's mother's house as one of John's assets? Needless to say, parents of divorcing parties need to take a long look at whether or not their estate plans need to be updated as well.
Conclusion
As a few concluding reminders, necessary paperwork to change beneficiary designations on insurance policies and retirement accounts must be gathered and submitted to your attorney. it's also beneficial to contact account custodians and brokerage firms as early as possible, to determine what letters or forms need to be signed by both parties when investment accounts and IRAs are being divided. In short, anyone who contemplates the potential post divorce stumbling blocks, in advance, will likely not find himself (or herself) tripping over one when the divorce is final.
The author wishes to express thanks to Nicole Lumberg for her assistance with the mortgage section of this article.
Endnotes
- Keep in mind that repeated instances of credit reports being requested could negatively impact a credit rating.
- It is important to note that there have been recent Michigan cases which conflict with Egelhoff and Bogg.
- A "qualified" plan receives special tax advantages from the. IRS and is qualified pursuant to requirements set forth under ERISA (Employee Retirement Income Security Act, 1974, as amended).