Raising cash during a divorce can include investment accounts, home equity loans, work retirements plans and 401(k) loans. Laura Kuntz CPA/PFS, MBT, discussed the pros and cons of these options in a Minnesota CLE Presentation called Family Law Finance – Client Financial Well-Being Post Divorce. A recording and transcript follow.
How do I raise cash? When raising cash for legal fees, raising cash for a home transition, raising cash or moving, raising cash for paying off debts, where do I go as the client to raise cash? Many times we are dealing with the spouse who is less financially sophisticated where they will say, “My husband handled all of that.” Or a man might say, “My wife handled that.”
So of course one of the first places to look is an investment account. We look at the investment account and we see how much taxable capital gain is there. What is the client’s likely capital gains tax rate? What are any costs to sell?
Another area of course that many of us will go to is a home equity line or a cash out refinance. And of course under the new tax rules that came into place December 2017, we know that a home equity line interest can only be tax deductible if that cash from the home equity line is used to improve the home. It’s got to be used for the home, it’s no longer tax deductible if it’s used for legal fees or to buy a car and all those kinds of things. And so that might give any of us pause in recommending to our client that they consider a home a home equity line for their legal fees or transition expenses. But I would suggest that you continue to think about a home equity line as an alternative because the interest being deductible is not the only factor to tax deductability. There’s also a question of how that fits within the new higher standard deduction versus itemizing, and they might not get to take that deduction anyway.
There are a couple of pieces there to think about. And also the home equity line interest might be attractively lower. It might be 4%, 5% even 6%, which isn’t awful for this kind of thing. And there may be a plan to pay that off over the next three years or four years. It might not be something that is long term. Also, I keep thinking about the fact that these new tax rules that came into place at the beginning of 2018 are scheduled to go away in 2026, and so we’ll be right back to the old tax system at that point, where home equity interest may be tax deductible and the whole standard and itemized deduction is different. I would continue to think about a home equity line or even a cash out refinance as a possibility to help folks with raising cash for legal fees and other transition costs.
Now another common one, of course, if there’s a work retirement plan that our client is receiving, is to consider to take a distribution pursuant to the QDRO. We all know that there’s no penalty on that, but of course there’s income tax and both at a federal and a state level. So that’s something to consider. What is that client’s likely tax bracket? Can they afford to lose a chunk of money to tax when we look at their retirement plan and are there other better alternatives? It’s little known that if a person has a work retirement plan, for many folks that are over age 55, the gray divorce, that they can often take a distribution from a retirement plan where they’re no longer an employee without a 10% penalty, much like taking a distribution pursuant to a QDRO.
One of the ones that clients will bring up and I’m very leery about is a 401(k) loan. At first, a 401(k) loan looks very attractive. A client will say, “Well, I’m just paying the interest. I know it has interest, but I’m paying it to myself.” True. But you also lose the growth on the investments, so that’s not free. But here’s the bigger thing. If you leave your job, you must repay it often within 60 to 90 days. That’s a really big deal. We have to know where is that money coming from. And even if you don’t lose your job, generally it must be repaid over five years. So I personally am very careful about 401(k) loans and often look to other alternatives.
Now, Linda mentioned tax planning in the year of divorce and making sure that you’re looking at all these items as you construct the J&D and it is very important. And I would say that the attorneys that we work with, I do find the J&Ds are very thorough and look at who should pay the tax on gains and who should pay the tax on liabilities that have been created and that sort of thing. And I think that that’s very, very helpful. And we’ve got a list in this slide of all the many things one might think about in terms of filing that tax return for the year of divorce. Of course, you’ve got head of household planning. I just mentioned you’ve got IRA Roth and 401(k) contribution planning. Of course, you’ve got the new higher standard deduction versus itemized deduction planning. And as Linda mentioned, considering the mortgage property tax and so forth and so on.
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Laura is a Senior Wealth Manager and the Founder of LWP. She has a master’s degree in tax and is an excellent listener. While she is a sophisticated financial planner with experience in complex issues, her priority is ensuring a financial plan works for people.