On Retirement

Divorce reduces retirement readiness

The new tax law could increase financial challenges for divorced people, but planning opportunities abound

Jun 19, 2018 @ 4:04 pm

By Mary Beth Franklin

It's no secret that divorce creates enormous emotional and financial challenges in the short run. But now a new report from the Center for Retirement Research at Boston College quantifies how divorce affects longer-term finances in the form of retirement readiness.

In 2006, the CRR developed the National Retirement Risk Index to measure the percentage of working-age households at risk of being unable to maintain their preretirement standard of living after they stopped working.

Today, the index shows that half of American households are at risk of being unable to maintain their standard of living in retirement. The risk is worse — 7 percentage points higher — for households that have been through a divorce.

While people benefit from economies of scale when they're married by sharing fundamental expenses such as housing and utilities, they typically face higher living costs per person after they divorce. Those higher living costs can also affect their ability to save for retirement.

Getting divorced when nearing retirement, a phenomenon known as "gray divorce," can be especially challenging as individuals who divorce at older ages do not have as much time to make up for assets lost to their spouse in a divorce. While the overall incidence of divorce in America is no longer rising, the divorce rate for people age 50 and older doubled between 1990 and 2010.

In a companion white paper released Tuesday, James Mahaney, vice president of strategic initiatives at Prudential Financial Inc., expounded on the financial implications of divorce and related planning opportunities.

Alimony, also known as spousal support or spousal maintenance, has been the one area that has been financially favorable to divorcing couples — at least until now. Alimony, which is paid by the higher-earning spouse to the lower-earning spouse, provides many divorced individuals with the money they need to support themselves. Although spousal support is gender-neutral by law, women receive 97% of alimony payments, according to the U.S. Census Bureau.

For divorces finalized by the end of 2018, the person paying alimony is able to deduct that expense from their gross income for federal income tax purposes and the spouse receiving alimony must report it as income. In some cases, the tax savings for the higher earner may make it possible for him or her to pay more in alimony that they could otherwise.

But the status quo is about to change as a result of the Tax Cut and Jobs Act. People getting divorced in 2019 and beyond who pay alimony will no longer be able to claim a tax deduction for those payments, and people receiving alimony will no longer have to report it as income. When these changes occur, a higher-earning spouse may no longer be able to afford to pay as much alimony as he had in the past, potentially leaving the recipient — usually the ex-wife — in a worse financial position. Complicating matters further, these new alimony rules expire on Dec. 31, 2025.

Mr. Mahaney cited some key financial issues that people may want to consider if they are contemplating divorce.

Investments. Beginning in 2019, people receiving alimony may find themselves in a very low tax bracket because alimony is no longer reportable as income. Consequently, they may qualify for a 0% tax rate on capital gains. If so, the lower-earning spouse may benefit more from receiving investment assets, rather than the marital home, in a property settlement. They may also be in a better position to convert traditional retirement assets to Roth IRAs to create future tax-free income.

Home ownership. Home ownership in states with high property taxes may become less attractive under the new tax law, which caps tax deductions for state and local taxes at $10,000 per year. It may make more sense for some divorced spouses to rent a home and claim the new larger standard deduction. Divorcing spouses age 62 or older can each use a reverse mortgage to buy a new home, reducing or eliminating future monthly mortgage payments.

Children and taxes. Personal exemption deductions have been eliminated from the federal tax code through 2025 and replaced by a more valuable child tax credit that reduces an individual's tax burden on a dollar-for-dollar basis. Therefore, determining which parent can claim a child post-divorce will be even more important over the next several years.

Social Security. It is important for divorced spouses to take maximum advantage of Social Security benefits. As long as a couple was married at least 10 years before divorcing and each spouse was born on or before Jan. 1, 1954, each person may be able to claim Social Security benefits on their ex-spouse's earnings record while their own retirement benefit continues to grow up to age 70.

(More: Divorce 2019: How to use IRAs and 401(k)s to ease future alimony planning)

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