How financial advisors guide client taxes through divorce

One of the best wedding gifts is a scanner, according to financial advisor Ekaterina Klimentova.

To explain why, the partner in the New York office of registered investment advisory firm Cerity Partners who is a certified public accountant as well as a certified divorce financial analyst shared the story of two clients’ divorces. One had shred all documents that were at least 10 years old. The other kept all of them, dating back 22 years or more.

“I unfortunately have had situations where records would really make a huge difference,” Klimentova said. “The person was a real hoarder and that really paid well for them. … The better you’re educated, the better you’re informed and the better records you have, you will always come out ahead.”

READ MORE: Divorce planning for clients: A guide for financial advisors

While lawyers play the lead role in representing divorcées during the legal agreement process, advisors and tax professionals must prepare their clients for the possibility of a divorce and guide them through the financial complexities of completing the formal separation of a marriage. 

Multifaceted and evolving family dynamics and technical tasks in the tax reckoning for prior estate-planning strategies such as increasingly popular spousal lifetime access trusts demand careful attention through a highly stressful time in clients’ lives. The IRS may compare the first return after the divorce to those from as long as three years earlier, according to Klimentova.

“It really becomes important not only to know what’s on it, but what your potential liability may be and how do you account for that in your divorce agreement?” she said. “There’s plenty of work for a tax professional or a financial advisor to do in a situation like that.”

Emotionally and financially taxing questions

Guides compiled by the IRS, advisor matchmaking and lead generation service SmartAsset and tax software firms H&R Block and TurboTax cover key questions about tax filing status, the filing of amended returns if the marriage is annulled (or treated as if it never happened), the need to file under the name registered with the Social Security Administration or change it and the handling of possible transfers of property or individual retirement account assets. Each employed spouse must tweak their tax withholding by filling out a new Form W-4. 

And the Tax Cuts and Jobs Act altered the tax treatment of alimony payments for divorces finalized in 2019 or later, so that financial support paid by one ex-spouse to another is no longer deductible to the one sending the money nor included in the taxable income of the one getting the dollars. In addition, the law ruled out any possible deductions for legal fees.

Some of the most difficult issues revolve around a couple’s children, whether in terms of how advisors’ emotional and behavioral roles in their clients’ lives may spill into psychology or in the complicated tax requirements connected to those topics.

READ MORE: Gray divorce can derail retirement. Here’s how advisors can help 

Child support payments are neither deductible or counted as income to the recipients, but only one spouse may claim a kid as a dependent — even if the custody is split 50-50. The spouse claiming the child as a dependent becomes the “custodial” parent and gets eligibility for the earned income tax credit and the child and dependent care tax credit. However, the non-custodial parent could get the child tax credit and additional child tax credit by filing Form 8332, which requires the signature of the custodial spouse.

“Generally, the parent with custody of a child can claim that child on their tax return to file as head of household or claim credits,” according to the IRS guidance on divorces and separations. “We might audit your return and ask for information to verify your claimed dependents and credits.”

From a technical perspective that also ties into the emotional side of money and wealth, even tougher topics could come up with the transition of assets. They could revolve around the treatment of capital gains, a qualified domestic relations order relating to alternate payees for retirement-plan benefits, possible gift-tax implications governing the timing of property transfers, so-called carryforwards and carrybacks and specific quandaries relating to family businesses, according to a 2022 guide to the key tax questions in divorces in the journal of the Association of International Certified Public Accountants, “The Tax Adviser,” by Amy Kinkaid and Charles Federanich of Pease Bell CPAs.

“Navigating a divorce can be an emotional experience for clients, and assisting them can likewise be poignant for their tax advisers, particularly when the adviser has a long-established relationship with both spouses,” Kinkaid and Federanich wrote. “Once a client notifies you they are contemplating a divorce and any potential conflict-of-interest matters are resolved, it is important to swiftly meet and address tax planning issues. It is imperative to collaborate with the divorce attorneys and investment advisors so that the time frame to plan and structure optimal tax outcomes for the parties is addressed and deadlines are met.”

READ MORE: Meet the CDFA, a certification for advisors with clients facing divorce

Start with the basics

Even though advisors may have been working with both spouses for many years, the conflicts involved with counseling them throughout the divorce on “very different” goals during the separation are so substantial that “it’s probably best for each of the parties to have their own advisors to get independent advice,” Klimentova said.

The financial ramifications of any possible separation in the future necessitate frequent and careful scrutiny of any prenuptial agreements. In fact, advisors should add them to the list of documents to request from incoming clients, Klimentova noted. Shaking off the dust from an agreement that may be decades-old can often prove a costly endeavor, and what sounded like an appropriate amount of spousal support to retain the same standard of living 20 years ago may not pay for a single credit card bill today, she said.

“Like any financial plan, it has to be a living, breathing thing. It’s never static,” Klimentova said. “By paying attention to these things, you could really help your clients out. The more you look, the more questions you ask, the better you’re off.”

READ MORE: Prenups protect more than clients’ money, divorce lawyers say

In that vein, tax advantages for spousal lifetime access trusts may have caused clients eager to get the savings to ignore how divorce represents a very real risk to the estate strategy. The separation would entail a careful accounting of the trust assets, Klimentova said.

“You’re basically giving up control of the asset,” she said. “This still can be evaluated and the attorneys really have to look at the situation, what was the intent, to see if there’s a possibility that these assets can be replaced by something else in the marital estate.”

At a basic level, while no advisor, tax pro or spouse can predict the future, they can perform the essential work of ensuring that both members of the couple take the time to educate themselves about their family’s finances. All too frequently, partners will say something along the lines of “‘Oh, my spouse handles the tax returns,'” according to Klimentova.

“It’s very important for any advisor to make sure to tell their clients to always, always pay attention to what is on your tax return,” she said. “The fact that you did not want to look at your return does not make you not liable for the potential tax penalties.”