Planning for Divorce and Unmarried Couples

Divorce and non-marital relationships present unique estate and financial planning challenges. CFP professionals must understand the tax implications of property transfers in divorce, the significant changes to alimony taxation under the Tax Cuts and Jobs Act (TCJA), and the critical estate planning gaps faced by unmarried couples.

Part 1: Divorce Planning

Property Transfers Incident to Divorce (IRC Section 1041)

One of the most important tax provisions in divorce planning is IRC Section 1041, which provides that property transfers between spouses (or former spouses) incident to divorce are treated as non-taxable events.

"Incident to Divorce" Definition: Property transfers qualify as "incident to divorce" if they occur:

1. Within one year after the date on which the marriage ceases, OR
2. Related to the cessation of the marriage and occurring within six years of the divorce

Even transfers after six years may qualify if the former spouses can demonstrate that factors (such as legal impediments or disputes) prevented the transfer from occurring sooner.

Important Basis Consideration: Because the receiving spouse inherits the transferor's original tax basis, any built-in gain in appreciated assets will be taxed when the receiving spouse eventually sells the property.

Example: Sarah transfers stock to her ex-husband David as part of their divorce settlement. Sarah's basis in the stock is $50,000, and its fair market value is $200,000. David receives the stock with a $50,000 basis. When David sells the stock for $220,000, he recognizes $170,000 in capital gain ($220,000 - $50,000).

QDRO: Qualified Domestic Relations Order

A Qualified Domestic Relations Order (QDRO) is the only legal mechanism to divide qualified retirement plans (401(k)s, pensions, 403(b)s) in a divorce without triggering taxes or penalties.

What Does NOT Require a QDRO:

• IRAs (traditional and Roth) - can be divided by direct transfer per the divorce decree
• Rollover IRAs - no QDRO needed
• Nonqualified deferred compensation plans - not subject to ERISA; divided per divorce agreement

Common QDRO Mistakes:

1. Assuming the divorce decree alone is sufficient (it is not; a separate QDRO is required)
2. Failing to obtain plan administrator approval before finalizing the divorce
3. Waiting too long after divorce to process the QDRO (the participant spouse may take distributions)

Alimony Taxation: The TCJA Game-Changer

The Tax Cuts and Jobs Act of 2017 fundamentally changed the tax treatment of alimony for divorce agreements executed after December 31, 2018.

Key Points on TCJA Alimony Rules:

• The new rules apply to divorce or separation agreements executed after December 31, 2018
• Pre-2019 agreements that are modified after December 31, 2018, can elect to apply the new rules (if expressly stated in the modification)
• Pre-2019 agreements that are not modified continue under the old rules
• The TCJA alimony provisions will NOT sunset even if other TCJA provisions expire after 2025

Planning Implication: Under the old rules, alimony was often paid by the higher-income spouse (who could deduct it at higher tax rates) to the lower-income spouse (who was taxed at lower rates), creating overall tax savings. The TCJA eliminated this planning opportunity for post-2018 agreements, potentially affecting settlement negotiations.

Child Support

Child support maintains the same tax treatment regardless of the TCJA:

2026 Note: The personal dependency exemption, suspended under TCJA from 2018-2025, may return in 2026 if the TCJA sunsets, potentially reviving negotiations over dependency exemptions in divorce settlements.

Updating Estate Plans After Divorce

A divorce creates an immediate need to update all estate planning documents:

State Law Considerations: Some states automatically revoke bequests to a former spouse upon divorce, but this varies by jurisdiction and does not apply to beneficiary designations on retirement accounts or life insurance. Never rely on automatic revocation.

Part 2: Estate Planning for Unmarried Couples

Unmarried couples, including domestic partners and long-term partners who choose not to marry, face significant estate planning disadvantages compared to married couples.

Key Differences: Married vs. Unmarried Couples

Critical Documents for Unmarried Couples

Because unmarried partners have no automatic legal rights, comprehensive documentation is essential:

1. Will or Revocable Trust: Names partner as beneficiary and potentially as executor/trustee
2. Beneficiary Designations: Update all retirement accounts, life insurance, and POD/TOD accounts to name partner
3. Durable Power of Attorney: Grants partner authority over financial matters if incapacitated
4. Healthcare Proxy/Medical POA: Authorizes partner to make medical decisions
5. HIPAA Authorization: Permits partner to access medical information
6. Cohabitation Agreement: Addresses property rights during the relationship

Financial Planning Strategies for Unmarried Couples

Life Insurance: Because unmarried partners cannot rely on the marital deduction or survivor benefits, life insurance is often critical to provide for a surviving partner:

• Name the partner as beneficiary
• Consider an ILIT if estate tax is a concern
• Life insurance proceeds are generally income tax-free to the beneficiary

Joint Ownership Considerations:

• Joint tenancy with right of survivorship provides automatic transfer at death
• Creating joint ownership may trigger gift tax if one partner contributes more than half
• Unmarried couples cannot use the gift tax marital deduction for transfers between partners

Annual Gifting: Unmarried partners can use the annual gift tax exclusion ($19,000 in 2025) to transfer assets without gift tax, but this is less efficient than the unlimited transfers available to married couples.

Gift and Estate Tax Exposure

For unmarried couples with significant assets:

Planning Opportunities

1. Use annual exclusions strategically: $19,000 per year (2025) can transfer significant wealth over time
2. Consider trust planning: Irrevocable trusts can remove assets from taxable estate
3. Life insurance: Provides tax-efficient wealth transfer to partner
4. Charitable planning: If no unlimited marital deduction is available, charitable strategies may reduce estate taxes
5. Business structures: LLCs or family partnerships can facilitate gradual wealth transfer

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Quiz: Divorce and Unmarried Couples Planning

Question 1: Jennifer and Mark divorced in 2024. As part of the settlement, Jennifer pays Mark $3,000 per month in alimony. Which statement correctly describes the tax treatment of these payments?

A) Jennifer can deduct the payments; Mark must report them as income B) Jennifer cannot deduct the payments; Mark does not report them as income C) The payments are split equally for tax purposes between Jennifer and Mark D) The tax treatment depends on which spouse has higher income

Answer: B

Explanation: For divorce agreements executed after December 31, 2018, alimony is NOT deductible by the payor and NOT taxable to the recipient under the TCJA. This rule applies to Jennifer and Mark's 2024 divorce. The pre-TCJA rules (deductible/taxable) only apply to divorce agreements executed before January 1, 2019.

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Question 2: David wants to divide his 401(k) account as part of his divorce settlement. His attorney tells him the divorce decree language is sufficient to split the account. This advice is:

A) Correct; the divorce decree is the only document needed B) Incorrect; a QDRO must be drafted, submitted to the plan administrator, and approved C) Correct only if the 401(k) balance is under $100,000 D) Incorrect; IRAs require a QDRO, but 401(k)s do not

Answer: B

Explanation: A Qualified Domestic Relations Order (QDRO) is required to divide a qualified retirement plan such as a 401(k). The QDRO must be approved by the plan administrator. A divorce decree alone is NOT sufficient. Note that IRAs (answer D) do NOT require a QDRO; they can be divided by direct transfer per the divorce decree.

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Question 3: Michael and his partner James have lived together for 15 years and own a home jointly. Michael dies with an estate worth $3 million, leaving everything to James. Which statement is TRUE?

A) James can claim the unlimited marital deduction to avoid estate tax B) James can elect portability to preserve Michael's unused exemption C) James has no access to the marital deduction or portability because they are unmarried D) James can claim half the marital deduction since they have lived together over 10 years

Answer: C

Explanation: The unlimited marital deduction and portability are available ONLY to legally married couples. Unmarried partners, regardless of the length of their relationship, cannot use these provisions. James will inherit Michael's $3 million estate using Michael's individual exemption amount (well within the $13.99 million threshold for 2025), so no estate tax is due in this case, but there is no marital deduction or portability available.