Three Sources of Divorce Income

In the divorce process, if one spouse has not been working or earns much less than the other spouse, their income needs are important to maximize. The decision to divide the household often has a negative effect on finances for the one with lower income, and both parties need a good understanding of income sources and where they come from. An important source of income (in addition to spousal support and Social Security, if around retirement age) comes from investments.

1.      Investment accounts can be divided in a straightforward way. Unlike retirement accounts, the unrealized capital gains (the difference between what the security was purchased for and its current market value) must be considered, to avoid an undue tax burden being placed on one spouse. In addition to tax considerations, if investments are to provide a source of income, the asset allocation should be carefully considered.

As noted in another post here, the investment accounts should not be cashed out prior to finalizing the divorce, so that your money is still working while the process continues. Most custodians will allow the securities to be transferred in-kind to a new account, so the money is divided between the two parties.

Currently, given low interest rates, cash is not providing much of a return. Even CDs (Certificates of Deposit) which usually have better rates as they require setting the money aside for some period of time, aren’t paying much. Therefore, money kept in cash, money markets, or CDs will not provide much of an income. Although it’s good practice to have some funds set aside in cash to be used in emergencies, someone who needs income can’t have too much of their portfolio tied up in these non-income-producing assets.

Bonds are providing more of an income than cash, but due to low interest rates, not much. They also serve as a cushion against the stock market fluctuations. Since the markets reward those who take risk, bear in mind that bonds with higher yields (interest payments) may be taking on more risk. Bonds paying out interest rates significantly higher than US Treasuries (currently around 1-2%) may be taking on credit risk, which means the companies issuing the bonds may be more likely to default.

Or higher-yielding bonds are taking on duration risk, meaning that the lengths of the bonds are longer in years, and these types of bonds are more sensitive to changes in the interest rate. So you might want to think twice about taking on a bond that’s promising 5% interest, because it may be exposing you to more risk than you plan or want.

Finally, income may be distributed from dividend-paying stocks as well. If you see stocks with huge dividend payout rates, that haven’t paid those dividends out before, you probably don’t want to buy them, as the rate is likely to drop again in the future. It’s better to buy stocks of companies that regularly pay out a dividend, because they’re less likely to cut their dividend payouts. The percentage paid out will likely not be very large, but combined with bond interest, you could build an income-producing portfolio.

If you’re not sure how to go about an income-producing portfolio, a financial planner can help you with that.

2.      Retirement accounts are another source of income to be considered if you’re at retirement age. There are penalties for withdrawing early, so make sure you’re old enough before you start taking money out. The rules are different depending on the type of retirement account, so it’s important for both spouses to know what types of retirement accounts are available to them. Because these accounts are typically pre-tax (unless the worker has a Roth account), ordinary income taxes are usually due on the full amount of the withdrawal.

Younger workers rarely have access to defined benefit accounts or pensions, but some older workers still do. Normally these require a QDRO (Qualified Domestic Relations Order) to divide between the spouses. The QDRO must be carefully drafted by the divorce attorney to ensure that the pension administrator will accept the order, and be entered before the divorce is final so that the division actually takes place. The worker’s pension is reduced by the amount awarded to the ex-spouse (unlike Social Security payments).

The present value of the pension can be calculated, and the ex-spouse can choose to take this as a lump-sum or an equivalent marital asset instead. Secondly, the ex-spouse can wait until the benefit is paid out in the future. If this is the case, it’s important for the ex to know whether the plan will pay out when the worker reaches retirement age, even if the worker chooses not to take the pension at that time.

The ex-spouse’s amount may have a coverture fraction applied to it, which takes into account the amount of time the couple was married during the worker’s tenure at the company. For example, a worker may have been at their company for twenty years. An ex-spouse who was married to the worker for the full twenty years could receive half the pension, whereas an ex married for ten years or half the time, might receive half of that half.

The benefit to deferring the payout into the future is that if the worker is farther away from retirement age, they could earn more and end up with a higher retirement benefit, which would then result in a higher payout for the ex as well. The disadvantage is that some pensions are underfunded, and the future payment might be in doubt. As a last resort, the court can retain authority to distribute at some time in the future, which leaves both parties in limbo as far as retirement planning.

Defined contribution plans such as 401(k)s, 403(b)s, and the government’s Thrift Savings Plan (TSP) are more frequently used in today’s labor market. Because they are employer-sponsored plans and subject to government regulation, they also require a QDRO to divide and are subject to the same caveats regarding drafting, in terms of making sure the administrator accepts the order and it is taken care of before the divorce is final to ensure that the division actually takes place.

Normally if a distribution from a (non-pension) retirement account takes place before the age of 59 ? there is a 10% penalty, but this is waived if the withdrawal is part of the QDRO. The administrator will still withhold 20% for income taxes on any distribution that is not rolled over to another retirement plan. Rollovers are not subject to either the 10% penalty or income tax withholding, as long as the funds go directly to another retirement account such as an employer plan or IRA.

IRAs themselves generally don’t require QDROs as they are not employer-sponsored plans, but the custodian or trustee may require the judge’s order or some other proof of the divorce in order to complete the division. If the ex-spouse doesn’t want to roll the IRA over, in order to avoid the 10% early withdrawal penalty if under the age of 59 ?, they can take “substantially equal periodic payments” per the IRS code 72(t), over the longer of five years or until they reach the age of 59 ?. Withdrawals from an IRA, like those from employer-sponsored plans, are taxable.

3.      Rental property may also provide income. Rentals are more work if you do it yourself, but then you won’t need to reduce your income by the fees of a management company. Keep an eye on the local market and make sure you’re not pricing too low (or too high). If no one is renting your place, the rent is probably too high. If your price is in line with the neighborhood, then you may need to renovate and make the place more modern or add conveniences that renters are used to in order for tenants to pay your price. You’ll want to have a budget for redecorating and renovating when necessary. However, you don’t want to price it too low either and leave money on the table.

One tendency that a lot of owners have, when they have good tenants in place, is to keep the rent the same. That may be fine for a year or two, but over the long term you won’t be charging an appropriate price. You might want to set your policy ahead of time, for example stating that the rent will be raised every two years in accordance with the cost of living increase. That way you don’t feel like you’re raising the rent on good people, you’re simply following your policy.

All of these sources may be considered when divorcing. It’s important for both parties to understand the basic finances of the household: what income is coming in through work, Social Security, or investments, and what the expenses are on an annual basis, so that each has a realistic view of what their financial lives will look like post-divorce. Understanding the household finances will also help them reach a settlement that will work in the future as well as in the short term.