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Planning for Retirement Post-Divorce

Carolyn Woodruff, a North Carolina CPA and Family Law Specialist, frequently is faced in sending a divorce client in the right direction after receiving a retirement plan in a divorce settlement.   Here are her thoughts on the subject:

The recipient may be receiving generally one or more of three types of retirement funds: (1) IRA; (2) 401k; and/or (3) defined benefit plan. Each type of plan should be evaluated as each has unique characteristics discussed hereafter.

Overall, there are four questions the divorcee should ask immediately post-divorce: (1) Age: What is my age now and at what age do I expect to retire? (2) Debt: What is my debt? Do I owe credit cards? Car debt? Is my home paid for? (3) Advisor: Do I need a financial planner or advisor, or am I competent to make investments myself? If the divorcee can do some basic investment herself, she can save administrative costs with mutual funds such as Vanguard. (4) Goal:  How much will I need for retirement adjusted for inflation? The goal is to develop a plan that achieves the goal with moderate or low-risk investments.

Hypothetical: A 40- year-old divorcee would like to retire at 67, which means she has 27 years to plan for retirement. Let’s say she has a 20-year mortgage on her newly acquired home, so this should be paid for before retirement, and perhaps available for a reverse mortgage at some point after retirement if needed. The availability of a reverse mortgage might be the source for medical bills in retirement.  However, she still has school debt, credit card debt and a car payment. She thinks that she will want $4000 per month in retirement after inflation adjustments are made. Let’s say she receives $100,000 in a 401k at the divorce, $20,000 in an IRA, and a small defined benefit plan that will pay $250 a month for her life when she is 67. Her predicted social security is $1500. So with social security at $1500 and the defined benefit plan at $250, she has $1750 of the needed $4000, so she has to make up $2,250 per month or $27,000 per year.. Let’s say her life expectancy is 88, but quite frankly it is good to plan for 100 so you do not out live your money. So that means the money needs to last for 33 years in retirement. The question is how does the divorcee plan for $27,000 per year for the 33 years? What is the amount of savings she will need to make up the $27,000.  At a planned withdrawal rate of  5 percent in retirement, this divorcee is going to need around $540,000  in retirement to meet her goal. At a planned withdrawal rate at retirement of 4 percent, she will need a nest egg of $675,000.  While a financial planner could do some allegedly precise calculations, here’s generally how the discussion will go. (I say allegedly because no one can be sure what inflation will be and what investment rate of return will be. Conservatively, the IRA should grow to at least $150,000 in 33 years. The $100,000 in the 401k should grow to make up the remainder of the needed money. So, the focus should be on investment vehicles that will turn the $20,000 in the IRA and the $100,000 in the 401k into $675,000 between now and retirement.

An Alternate Payee is the spouse of a Plan Participant who receives benefits under a Plan via a Qualified Domestic Relations Order. This discussion assumes the QDRO is already in plan from the divorce.

A defined benefit plan usually is divided as a percentage of the Plan Participant’s future benefit stream, which is probably a monthly benefit at some future retirement age. Most Defined Benefit Plans control the investments and the Alternate Payee (the person who is not the Plan Participant) has no choice of investments, but probably has choices of how to take the future annuity, such as singe life or joint and survivor annuity with another person.  An example might be that the Alternate Payee might receive $1000 per month for life. Or, $800 per month for her life and the life of a new spouse. These defined benefit plans work much like annuities. Government and military plans would fall into this category, and the big thing with these plans is making sure all the documentation is in the right place at the right time. Private industry also sometimes use Defined Benefit Plans. Since the asset allocation is not controlled by the Alternate Payee, the post-divorce planning for the Alternate Payee is understanding how this future monthly benefit fits in with the total need for the retirement budget.

There is an option for a 401k that is not available to the divorcee under IRAs or Defined Benefit Plans. There is a one- time exception to the 10 percent penalty for a lump sum or partial lump sum withdrawal to the Alternate Payee upon the qualification of the Domestic Relations Order by the Plan Administrator (QDRO) FREE of the 10 percent penalty under Internal Revenue Code Section 71t. Thus, the divorcee in our example could take $20,000 out of the $100,000 401k at the time of the QDRO and roll $80,000 into an IRA. This is available one time only at the time of the initial elections under the retirement account. The $20,000 does go on the tax return at ordinary income rates, but there is NO 10 percent penalty. If the divorcee can meet her retirement requirements, she might want to pay off some of the credit card debt, which presumably has high interest rates. Most 401k plans require the Alternate Payee to roll the 401k funds into an IRA.

The divorcee might also consider whether a Roth IRA fits into her plan. The decision will revolve around her current income tax rate.

I like to see a re-balancing of retirement plan investments annually. Of course, the mix of investments will depend on risk tolerance and age. At retirement, my opinion is around 50 percent should be in blue chip equities or equity funds and reduce this by two percent per year in retirement.

I am not a fan of Long Term Care Insurance, and prefer the equity in person’s home and all the Medicare-gap insurance. If this is a fear factor, increase the savings rate after divorce in a 401k, IRA, or other savings account. Certainly, save the maximum available in a Health Savings Plan, if that is available to the person.

The biggest mistakes I see after divorce:

  1. Selection of a financial advisor that does not properly assess risk or is too risk-oriented to make commissions for himself.
  2. Failure to check on beneficiary designations and keep these updated.
  3. Failure to plan to pay off high-interest rate debt, such as credit cards. Remember the one-time election on the 401k by the alternate payee.
  4. Failure to make use of 401k employer matching, when available through a new job.
  5. Failure to plan to have a paid-for home at the time of retirement.