The Bogleheads' Guide to Retirement Planning (49 page)

As an example of how things can go wrong, recall the order that divided a defined benefit plan with a benefit of $1,000 monthly between parties who were married 10 years. Suppose that several years after the divorce, the employer is downsizing and offers the employee spouse a buyout where, in lieu of retiring with benefits, the employee is offered cash. If the QDRO does not divide the plan until the time of retirement and the employee elects the cash payment, then the nonemployee spouse’s half interest may never come into being and that spouse gets nothing.

The same scenario can happen in a divorce where one spouse is in the military. The Uniformed Services Former Spouses Protection Act (10 USC 1408) allows divorce courts to divide military retirement pay and prohibits the division of disability benefits. The U.S. Supreme Court ruled that a nonmilitary spouse could not prevent the other spouse from accepting disability payments in lieu of retirement pay and that the objecting spouse was not entitled to share in the disability pay elected in lieu of retirement pay.

There are other special rules for dividing military retirement in a divorce. A QDRO is not required. The spouses must have been married 10 years during which the military spouse served 10 years before a court can divide the military pension. The division can never take more than 50 percent of the retirement pay. These rules are explained quite well at
www.dfas.mil
.

Social Security benefits are not divided or awarded in a divorce. Do not expect to receive half of your spouse’s Social Security benefits. Recall that the right to receive Social Security is derived from working for a sufficient number of years to qualify. The size of the benefit is based on the length of employment and amount of income.

A spouse may only get survivor’s benefits based on the other spouse’s employment and income. If you divorced more than 2 years prior to requesting benefits and the marriage lasted more than 10 years, then you may receive benefits based on your former spouse’s income. These benefits may be more than you qualify for on your own. If you remarry, you lose the right to apply for benefits based on your previous marriage but may qualify for benefits through your current spouse. Alternatively, you may qualify for benefits based on your own circumstance and employment history, whether you are married or divorced.

The general rule that assets acquired during a marriage are divided equally has exceptions that vary from state to state. As mentioned, property acquired prior to the marriage and kept separate is not usually divided, and its value does not enter into the division. Similarly, if one spouse inherits or is gifted property and that property is kept separate, such as funds in a brokerage account in just that spouse’s name, then that asset will not usually be subject to division.

A couple can also agree prior to marriage about how property may be divided or remain separate. This brings us to the subject of premarital agreements, which are also known as prenuptial and antenuptial agreements. They are written agreements between spouses entered before marriage that govern which spouse will have an interest in property the other spouse might claim in the event of separation or divorce.

In the eyes of many, premarital agreements developed an undeserved reputation of being unfair, or that people who entered into them were less dedicated to the marriage than people who do not have them. There are a lot of good reasons for a premarital agreement. Entering into the agreement can help a couple get used to talking about money and property. They can make rules that they prefer to their state’s property or inheritance laws. Older individuals may want to keep property separate so it can be given to children of an earlier marriage. Areas where a state’s law is vague or unpredictable can be clarified by the premarital agreement. In other words, the couple can plan the economics of their marriage in advance.

In the event of divorce or death, expensive litigation can be avoided. Premarital agreements have an estate planning use even if a couple never divorce. State laws regarding inheritance can restrict the manner or extent that marital property can be given away by a will. Typically, a third to half of marital property must be given to a spouse, or the spouse can elect to receive that much, even if the will has a different provision. These restrictions can be avoided if the property is kept separate by use of a premarital agreement.

All 50 states enforce premarital agreements. To be enforced, they must be fair—that is, not unconscionable or significantly imbalanced. The process of reaching the agreement must be free of coercion, and there must be a full and accurate disclosure of assets, debts, and the effect of the agreement. The agreement must be written. The process by which the agreement is reached is more important than the actual terms. It is wise to have two lawyers involved.

Common provisions dealing with retirement plans may provide that a plan or plans remain separate property, even if the spouse continues making contributions to the plan from marital income. The agreement may specify that if one spouse gives the other money to fund their retirement plan, that gift will not convert the plan to marital property. The agreement may create a fund that will be given to a spouse in lieu of a retirement plan or it may define the spouse’s interest in the retirement plan. Another provision may require one spouse to buy the other a retirement annuity to make up for the fact the spouse will not be working, and accruing retirement, while raising children. Child support can never be waived in a premarital agreement. In a number of states, spousal support cannot be waived in a premarital agreement.

If you marry without a premarital agreement, an increasing number of states will enforce postmarital agreements. These agreements can cover the same subjects as premarital agreements. In the event of a dispute, the postmarital agreement is more closely scrutinized to see that it is fair and that the process leading up to it was fair. Involving attorneys in the preparation of a postmarital agreement is a good idea.

Note that a division of property in a divorce may not be the last word on everything you own that has been discussed in this book. Certain assets, such as life insurance and IRA assets, pass to designated beneficiaries if you die. A divorce decree will not change the designations. If you get divorced, you should immediately review all beneficiary designations to ensure your property is received by the person of your choice.

Professionals who counsel people experiencing financial difficulties will tell you that only a minority of them are to blame. Accidents not covered by insurance, job loss, family members who need help, and unanticipated illness can create a financial emergency without anyone being at fault. That means a financial disaster can happen to you. Here is some information that may be of use to you if a financial crisis occurs in your life.

The first concern is whether your retirement funds can be taken from you by creditors. Any plan that is covered by Employee Retirement Income Security Act (ERISA) is protected from the claims of creditors and prevents any creditor from going to a plan administrator and demanding either money in your account or payment of any portion of your monthly benefit check. The fact that debt may have been reduced to a judgment does not change the fact that all ERISA plans are exempt from the claims of your creditors. There is no dollar limitation to this protection, and all money in an ERISA plan is exempt from creditor attachments. This is true if you file bankruptcy or do not file bankruptcy. So, the answer to your question about whether your private defined benefit plan, defined contribution plan, profit sharing, 403(b) annuity, or similar plan could be taken from you is
no
.

Although there are state laws that partially protect assets in an IRA from creditors, ERISA does not apply to IRA accounts. About half the states prevent judgment creditors from attaching money in an IRA account. These state laws are called exemption laws. They usually contain a dollar limit such as protecting only the first $100,000 in an IRA, or they limit their protection to amounts reasonably necessary for the support or sustenance of a debtor or dependent. The IRS can always seize money in IRA account regardless of state law.

Exemption laws do not protect money in personal accounts or brokerage accounts from seizure by judgment creditors. Accordingly, you should maximize money in qualified plans.

Various trust arrangements including charitable remainder trusts have been discussed in this book. The general rule applicable in all jurisdictions is that if you set up and fund a trust, including a charitable trust, the trust will not protect the money you give to it or your right to the trust’s earnings from the claims of your creditors. If you are told that setting up a trust will protect assets transferred to it from the claims of the creditors, you need to know that any creditor who wants to go to court can void the trust. This rule is true if you file bankruptcy.

You can provide in a trust you set up and fund for others that the creditors of those beneficiaries cannot invade either the principle or earnings of the trust. This is called a spendthrift clause.

Withdrawing money from your tax-sheltered retirement plan may seem like a good idea in the middle of a financial crisis. The key questions are whether you can or should. You can withdraw money from an IRA tax-free as long as you pay the money back into the IRA within 60 days. If you do not, you will be subject to the early withdrawal tax penalty equal to 10 percent of the withdrawal amount on top of income taxes if you are not yet 59½ years of age. ERISA-qualified plans may allow you to withdraw money as a hardship distribution. These are limited by federal law to withdrawals to keep your principal residence out of foreclosure, for a medical emergency, or to pay for postsecondary education for you or a dependent. You will still have to pay taxes on the withdrawal and may still be subject to the 10 percent penalty. Check with your tax adviser.

Many ERISA plans allow you to borrow money from the plan up to a specified percentage. Assuming you enter into such a loan and pay it back, there is no tax consequence. If you do not repay the loan, amounts outstanding are treated as an early distribution, and you are liable for the taxes on the withdrawal plus the 10 percent penalty if you are not yet 59½ years of age.

Develop a plan that takes you from the beginning of the financial emergency to the end before prematurely withdrawing money from any retirement account to deal with a problem. You should feel certain that the financial emergency will end before it is worth using your retirement account funds to pay creditors. It may be wiser to leave the money in a retirement plan and file bankruptcy if withdrawing money from a retirement plan will not solve your problem. You can take a retirement account through a bankruptcy without losing it.

As soon as you realize you have a financial crisis, sit down and list all your financial resources and liabilities. Resources include your income and things you might sell. Also include spending you might forgo and amounts other people might give you to help out. Then list all the people you owe now and will owe in the future. You need to budget your way through your financial difficulty.

Be accurate when doing this exercise. Review your checkbook and financial accounts for spending you put on a credit card. You also need to account for expenses that occur intermittently, such as car repairs or annual registration. As an example, most people, if asked how much they spend on food, will give a low figure because they will forget to include restaurant meals.

Prepare a forward-looking budget to find ways to spend no more than the amounts provided in revenue. Generalized resolutions to spend less rarely work unless you have a mechanism to stop expenses before you exceed any item in the budget. You need to prioritize, assuming the budget will not pay all debt when it comes due. Higher priority debt is debt that is secured by some asset you would not want to lose. Your home mortgage and car loan are high-priority debt. Debts that will not go away in a bankruptcy are also priority debts. Child or spousal support falls into this category, as does the IRS.

If you have two home mortgages secured by your residence, the first mortgage is a higher priority debt than the second mortgage. The first has greater rights to its collateral, your home. That is the reason the lender on the first mortgage has less of an incentive to work with you than a second-mortgage holder. Do not omit making the payment on the first mortgage and pay the second because that payment amount is lower. If you do this for long, the first mortgage will foreclose, and the holder of the second mortgage will not help you keep the house.

Companies holding first mortgages do not like to receive partial payments and may even mail back your check. If you cannot make a whole payment on a first mortgage, make a payment with the late charge when you can. For example, if all you can afford is half a payment a month, send a full payment and late charge every other month, rather than a half payment each month. If you realize you cannot afford to keep both your house and your car, it is best to decide which you will give up before things get so bad you lose both.

If you miss a payment on your home mortgage, you receive a few calls and letters over a four-month period, and then the lender sends your file to a foreclosure trustee who will take the house from you in one to four months, depending on your state’s foreclosure period.