Wills, trusts, retirement accounts and related documents are rarely top of mind during the intense, emotional process of dissolving a marriage. Too often wealth “planning” ends with canceling joint credit cards and closing joint checking accounts before estranged spouses can empty them. However, a thorough review of the client’s overall estate plan and estate and retirement planning documents often reveals critical issues that merit attention during or soon after the divorce proceedings.

Wills, trusts and other important estate planning documents may be significantly affected by the dissolution due to the changed intentions of the client. However, these and other documents are often overlooked. Depending on the state, provisions in the will and trust favoring the former spouse could be revoked by function of law. Additionally, some states are enacting legislation to treat the beneficiaries of IRAs, life insurance policies and annuities in a similar fashion. Such statutory revocation of outdated provisions may lead to confusion. In addition, trust documents may need modification to protect the interests of heirs who are minors. And without a spouse to provide an effective deferral of estate taxes under the marital deduction, there may be liquidity problems at the passing of the first ex-spouse.

It is also important to update the client’s documents if they still name the former spouse in an official capacity to administer the estate. For instance, a client does not typically want the former spouse to be his or her Executor/Personal Representative, Attorney-in-Fact, Trustee or Health Care Surrogate. It is prudent to address these issues at the time of divorce rather than risk overlooking them.

Trusts in Divorce

Family Trusts

Clients who are divorcing are often confused and emotional over the treatment of assets inherited during or before the marriage. How could their beneficial interests in their parents’ trusts be subject to division during their own divorce? Aren’t gifted or inherited assets excluded from the marital estate? This may have been a general rule of thumb in the past. However, it may not hold true if these were commingled or served as sources of funds to support the marital lifestyle. Furthermore, in practice, depending on state law, family courts may now have broad discretion and may consider inheritances when determining support obligations and/or property settlements.

Spendthrift provisions in trust documents have typically protected beneficiaries’ current interests in irrevocable trusts created by third parties. Increasingly, this treatment now varies by jurisdiction. There appears to be a growing trend to consider spouses, former spouses and children as exception creditors to the protection of a spendthrift clause. Citing public policy considerations, some states’ versions of the Uniform Trust Code (UTC) allow former spouses and children to attach or access otherwise protected trust assets under certain conditions.

In the past, family law courts have not generally considered future or contingent inheritances as marital assets when determining property settlements or support. However, even if such future inheritances are not included in the plan of division by law, they can be a factor influencing strategy during divorce proceedings. It is not uncommon for a spouse’s divorce attorney to request copies of the opposing spouse’s parents’ estate plans during the discovery phase of divorce litigation.

Charitable Remainder Trusts

Affluent clients who are charitably inclined may also have established Charitable Remainder Trusts (CRTs) during their marriage. These trusts have provided them with an income tax deduction and allowed them to take advantage of capital gains tax deferral when diversifying large positions in highly appreciated securities. Often, these trusts have been established for “two lives”, meaning that the CRT’s regular pay-outs are to continue for the lifetime of the second to die.

Negative consequences of a two-life CRT can be significant once the parties have dissolved their marriage. For instance, if the grantor dies first, leaving the former spouse as the beneficiary, Federal tax law does not allow a marital deduction for the surviving party’s interest in this trust. Consequently, the actuarial value of the income stream the surviving party expects to receive may cause estate taxes for the grantor’s estate. The CRT document could contain a provision shifting responsibility for this portion of the grantor’s estate tax to the surviving party. However, regardless of who pays the tax, it is likely to be an unpleasant surprise for the client.

Fortunately, the IRS allows what is becoming a common remedy in these situations. The CRT can be divided into two new CRTs, with each spouse receiving a life interest his or her portion and the remainder continuing on for the original charitable remaindermen. The tax basis and holding periods for the assets in the two new CRTs are the same as those in the original CRT. No negative gift, income or estate tax consequences occur from this split if the parties follow all of the tax law provisions. The IRS has issued a number of Private Letter Rulings ratifying this procedure, including PLRs 200539008, 20045038, and 200143028.

Trusts Created During Divorce

Although not part of traditional estate plans, trusts may be created during the divorce process to address certain situations. For instance, in cases where a client is unable or unwilling to have any ongoing contact with the former spouse, an “alimony trust” may be a good alternative to periodic alimony payments.

Alimony trusts are normally funded with cash, securities, and/or business interests. The trusts are irrevocable and in their simplest form the recipient spouse is the sole current beneficiary. Such trusts provide assurance to this spouse because the assets are segregated and supervised by a trustee. Additionally, these trusts may protect the spouse from quickly dissipating the assets or falling victim to undue influence. However, although the funding amount is negotiable, contributing a lump sum up front can present a challenge for the obligor spouse.

The usual tax treatment of alimony trusts is consistent with that of typical irrevocable trusts under Federal tax law. Under Internal Revenue Code Section 682, the conduit rules for trust distributions apply. As the income flows out of the trust, the recipient spouse includes it on his or her tax return; any amounts received in excess of the trust’s net income are considered tax-free returns of corpus. The obligor spouse does not get an income tax deduction for funding the alimony trust but neither does this spouse include the trust’s income on his or her personal tax return, as would be the case if s/he still owned the assets generalizing the periodic alimony stream.

However, in a few situations, it may make sense to structure an alimony trust as a grantor trust, so that the payor spouse is also taxed on the income and capital gains earned by the trust. This may be helpful if the payor spouse has a large current or carryforward tax loss to offset some of the extra income that will be attributed to him/her.

Trusts may also be created during divorce negotiations to address estate planning issues. For instance, if either spouse does not trust the other to leave sufficient funds for their children, an irrevocable trust may solve this concern. If some of the marital assets are expected to grow significantly faster than the current rate imputed by the IRS, a GRAT may be a winning substitute for alimony with an inheritance motive at the end.

If a non-citizen spouse is involved, creative planning can solve a thorny issue. Gifts and inheritances to a spouse who is not a citizen, even if that person is a long-time resident married to a U. S. citizen must be placed in a Qualified Domestic Trust (QDOT) or be subject to immediate transfer tax. However, these same funds can be transferred to the non-citizen, pursuant to a divorce under Section 2516, without any tax. This can be a helpful negotiating chip!

Retirement Plans

Retirement plans now represent a significant part of the net worth of many families. Oftentimes, the majority of a couple’s liquid assets reside in pensions and individual retirement accounts. As a result of their special tax treatment and government protection, retirement assets should not be divided between divorcing spouses merely by allocating the face value shown on the most recent statement.

Assets residing in retirement plans have usually been accorded advantageous tax treatment. There is typically an income tax deduction at the time of contribution and deferral of ordinary income tax and capital gains tax while the funds remain in the plan. In addition, as a matter of public policy, federal, and state governments protect plan participants and their families by overseeing many of the legal and administrative aspects of retirement plans.

These benefits during the funding and accumulation phases come at a cost – distributions out of retirement plans are governed by a labyrinth of complex rules. These can be particularly onerous when dividing plan assets during a divorce.

Note that Roth IRAs are entirely different in terms of tax treatment. There is minimal embedded tax liability in a Roth IRA. Until recently, Roth IRAs were typically very small, as they had been in existence less than a decade and contributions had only been available to taxpayers with modest incomes. Since during divorce settlements these pose few of the same issues as traditional IRAs, this article does not deal with the treatment of these accounts.

Two Types of Retirement Plans

The most common forms of retirement plans fall into one of two categories:

1. Qualified Pension Plans (QRPs) are usually set up by employers as employee benefits. They are subject to federal tax and labor laws (Internal Revenue Code and ERISA) and are overseen by the Internal Revenue Service, the Pension Benefit Guaranty Corporation and the Department of Labor.
2. Individual Retirement Accounts (IRAs) are established by individuals. IRA assets are held by financial institutions in the capacity of custodians or trustees for the benefit of the individual account holders. IRAs were originally small accounts consisting of the taxpayers’ annual contributions of $2,000 - $5,000. Large IRAs funded by rollovers from qualified retirement plans are becoming increasingly common. While the tax treatment of IRAs is subject to federal rules under the Internal Revenue Code, many of the legal and administrative issues are governed by state law.

As a result of the different orientation and governing laws between QRPs and IRAs, there are significant differences in the tax and administrative treatment of distributions and transfers.

Qualified Retirement Plans (QRPs) in Divorce

The transfer of all or part of a QRP in divorce proceedings requires a Qualified Domestic Relations Order (QDRO). A QDRO is a judgment or order made pursuant to state domestic relations law. It names an alternate payee or payees – for instance, a soon-to-be ex-spouse – to whom plan assets can be transferred without penalty or taxes.

Before transferring any funds, the QRP administrator must assure that the QDRO is properly drafted. This is a major responsibility, as failure to observe the format, content, and procedural requirements can cause immediate taxation of the QRP to the participant and/or jeopardize the qualified status of the entire plan. Before starting to draft a QDRO, attorneys may find it worthwhile to contact the QRP administrator to see if that plan uses a standard form for QDROs. If not, it is wise to send the administrator a draft of the proposed QDRO for review before execution.

Although there are no taxes or penalties at the time a transfer is made under a QDRO, the alternate payee pays ordinary income tax when withdrawing any funds. If the plan consisted partially or entirely of after-tax contributions, the original basis is allocated pro rata between the original participant and the alternate payee.

Recipient spouses have two options for handling assets received under a QDRO:

1| Roll the assets into their own IRA. This is often a first choice, as it usually gives greater control over investment choices, costs and beneficiary designations. Psychologically, it is also appealing in that it provides immediate distance from the ex-spouse.
2| Retain the assets in the QRP. A recipient spouse who is not yet 59 ½ and who may need to withdraw some of these funds prior to becoming 59 ½ may find it advantageous to keep at least some of the money with the original plan custodian, because the 10% early withdrawal penalty is waived in a QDRO situation. A QRP may also provide additional advantages specific to some recipients.

Individual Retirement Accounts (IRAs) in Divorce

The tax aspects of IRAs are governed by the Internal Revenue Code Section 408(d)(6). State laws control many of the legal and administrative issues, such as creditor protection and inheritance.

The transfer of IRA assets pursuant to a divorce decree or written agreement incident to divorce is non-taxable. QDROs are not required and are not appropriate when transferring IRA assets in divorces.

The many financial institutions acting as IRA custodians and trustees offer a variety of ways of effecting the actual transfer. We strongly advise a trustee-to-trustee transfer of assets from the payor spouse’s IRA to the recipient spouse’s IRA. If the recipient spouse doesn’t already have an IRA, he or she should first set one up at the institution of his/her choice, then make the transfer.

Once the assets are in the recipient spouse’s IRA, all the regular IRA rules apply to that spouse as owner, including the Required Minimum Distributions at age 70½ and the 10% early withdrawal penalty for distributions prior to age 59½. The new owner can even contribute more funds annually if s/he has sufficient income (and per IRC Section 219(f)(1), alimony is treated as “earned income” for this purpose). The recipient spouse can and should name his own primary and contingent beneficiaries.

It is important to note that inherited IRAs are not divisible in divorce without negative tax consequences. If part or all of an inherited IRA is transferred to a new owner, even pursuant to a divorce settlement or court order, that portion is deemed a distribution. This incurs immediate taxation – to the original owner!

Importance of Embedded Taxes

The embedded income tax liability in marital assets is a significant issue that is all too often overlooked in the emotion of a divorce settlement. To achieve an equitable division, assets should be evaluated on an after-tax basis.

For example, a spouse in the 35% marginal income tax bracket who receives $500,000 of IRA assets may actually only receive $325,000 in current spending dollars. If the other spouse is in a lower bracket the best win-win solution could be to allocate the IRA to that spouse and give the higher income taxpayer an equivalent amount in cash or other assets. However, this analysis can become much more complex if one or both spouses does not expect to withdraw retirement plan assets for many years, and anticipates being in a lower bracket when doing so. However, a caveat is in order here: even if a taxpayer’s gross income is less in his future retirement, as tax rates increase from their all-time low, s/he may be taxed at an equivalent or higher rate!

Conclusion

Divorce mandates a thorough review of a broad spectrum of estate planning documents. Wills, trusts, and other traditional estate planning documents will most likely need to be updated. QRPs and IRAs often represent key components of the marital assets but are governed by unique tax rules and subject to special regulatory oversight. When negotiating a property settlement, clients and their advisors who are unaware of the hidden issues may be unpleasantly surprised at the net after-tax result and/or ultimate disposition of their final settlement.

Guest author:

Joan K. Crain