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Wilmington Trust | Divorce

How to Stress Test Your Divorce Plan

Our team provides insights on some important divorce planning topics to consider, including life insurance, alimony, trust planning, cash flow, asset division, and more.

Watch Our LinkedIn Live Stream: How to Stress Test a Divorce Plan                                                                                          

Our divorce planning professionals Sharon Klein and Christy Watkins discuss ways to stress test every divorce plan so your clients can be well-positioned for the future. 

For more information about how we can assist with the complexities of divorce and premarital planning, please contact Sharon Klein.

Q&A from our LinkedIn Live Stream: How to Stress Test Your Divorce Plan

Our divorce planning professionals Sharon Klein and Christy Watkins answer some important questions posed during our LinkedIn Live stream.

No, getting an in-force illustration is not the same as a policy review. While an in-force illustration can provide important information, a thorough policy review should be completed by an outside, neutral, expert organization (not the broker who sold the insurance). This type of review encompasses whether the policy is performing, an analysis of the strength of the insurance company, whether the type of policy is still appropriate having regard to factors like whether the health of the insured, market conditions or the original goal in purchasing the insurance has changed, comparisons with different options to check if premium amounts/death benefits are competitive in the current environment or whether an exchange should be considered to obtain more attractive/less expensive coverage. Wilmington Trust uses such an outside third party to review insurance when we act as trustee of life insurance trusts. Please feel free to reach out to me for further guidance, tips, and best practices for life insurance reviews.

The complication that arises when splitting assets based upon different risk levels is that it often results in an uneven split of tax consequences. Generally, lower risk assets often have a higher relative tax basis and higher risk assets often have lower relative tax basis. If the assets are split based upon risk tolerance, one ex-spouse may find he/she is at a disadvantage when he/she ultimately plans to sell assets and the tax bill comes due. At the same time, if both individuals receive assets that are out of line with their risk tolerance, there are real costs of capital gains taxes and trading costs to realign the portfolios consistent with their risk tolerance. Each situation is unique requiring a thorough review of the assets down to individual tax lots in order to see what can be accomplished to distribute assets in a proportion consistent with risk levels while maintaining a fair split of the tax basis.

Due to a recent change in the law, certain trusts that are often among the staples of estate planning for married couples can now have unintended tax consequences: If one spouse created a trust during the marriage and the other spouse could get distributions, the spouse who created the trust may continue to be liable to pay the taxes on distributions made after a divorce to their ex-spouse-forever! However, if you create a trust incident to divorce (i.e., within one year of divorce or within six years pursuant to a written marital settlement agreement or divorce decree), but after divorce so the parties are no longer married, there shouldn’t be any income or gift tax implications. The ex-spouse income beneficiary would be taxed on distributions as per the normal rules (avoids the problem that the grantor/creator spouse would continue to be taxed on distributions to an ex-spouse). Since, for divorces beginning in 2019, alimony is no longer tax deductible to the payor or includable in the income of the recipient, that change has eliminated the previous income tax arbitrage of having a higher tax bracket payor push distributions to be taxed in a lower bracket recipient for on-going alimony payments. 

At the outset of building the projection, it is imperative to build a holistic picture of all assets and liabilities including tangible or non-financial assets. These assets should be considered to ensure overall diversification when combined with the financial assets. As an example, when an individual owns a number of real estate holdings that encompass a significant portion of their wealth, he/she should not have real estate related securities in his/her financial assets. It is important to diversify the types of risks any individual is exposed to across all types of assets. Separately, if these tangible or nonfinancial assets are held for investment purposes and are available to be liquidated in order to cover future expenses, he/she should also be incorporated with the financial assets in the sustainability analysis.

You just need a Delaware trustee to create a Delaware Asset Protection Trust (DAPT). Neither the trust creator nor any of the trust beneficiaries need to live in Delaware. Liquid assets would be administered and serviced by a Delaware team, so no hard assets need to be located in Delaware. If you’ve never done a DAPT before, we would be happy to connect you with a Delaware attorney, and we do recommend that a Delaware attorney review drafts of DAPTs. It can be a simple and inexpensive process to get Delaware counsel involved and, as noted, we would be pleased to recommend some attorneys. We would say at least $3 million would make a DAPT worthwhile, but it depends on the level of family wealth. Since DAPTs have an “escape hatch” in that the creator can get access to the assets if needed, people are more comfortable funding with larger amounts than they would be if there was no possibility of future access. That said, the DAPT assets should be considered “rainy day” funds, and not as go-to source of funds. Most people have peace of mind knowing the assets are accessible in case of emergency.

In these situations, we find it is best to start from the bottom up by using a sample budget in estimating regular expenses. In walking through each item line by line, the dialogue helps to stimulate areas of expense based upon an anticipated lifestyle. By asking open questions such as: ”Where do you plan to live?” “How often do you intend to travel?” and “Where would you like to have a membership?” we are able to build a picture of a future lifestyle and help establish an estimate of what that lifestyle will cost. This process helps to build a foundation of financial concepts along with awareness on your part of the breakdown in their costs between more necessary and more discretionary items. With a divorce pending, it is difficult to have an accurate picture of future expenses, no matter the financial expertise of the individual. It is important to establish a range of costs for this lifestyle in order to achieve a sense of confidence that the proposed settlement will be sustainable for the long term.

It’s all about the team! A trusted team of experts can help best position clients for success. Working with a family law attorney, an estate planning attorney, an accountant, and insurance or other experts, a financial advisor will typically be a central member of the team in helping ask the right questions across disciplines to produce financial analytics to leverage at the negotiating table, and beyond. Many key areas need to be integrated, including taxes, income expectations, property analysis, lifestyle aspirations, family situation, and legacy objectives. A seasoned financial advisor will assist not only in asking the key questions, but will also provide clients with guidance, education and support across these areas, delivered with compassion and sensitivity.