Journal of Financial Planning: August 2022
Mark Prendergast, CFP®, CPA, CDFA, is the director of tax strategies at Inspired Financial, a financial planning firm that focuses on women in transition, in Huntington Beach, California. He specializes in tax, estate, and divorce planning. Mark has served in FPA leadership positions at the chapter, state, and national levels.
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During divorce proceedings, the financial planner and the client rarely think about estate planning. Gray divorce is a generic term for divorce after age 50, the fastest growing demographic for divorce; therefore, the estate planning topic should not be ignored.
We discuss which estate planning techniques can and cannot be executed during the divorce process. We follow with practical applications in dealing with common issues that can arise to better position the client in the event that death or incapacity occurs while the marital estate is under the jurisdiction of the family law court.
Divorce/marital/family law, hereinafter referred to as “family law,” is state-specific. Many of the techniques discussed herein are common to most states and some will be contrary to the client’s resident state’s law. If the discussed technique does not apply to the client’s state, then the planner needs to consider other alternatives or accept that it is impermissible. The planner should view this as an outline of potential issues and an opportunity to learn their state’s provisions. Certainly, no estate planning action should be taken without the approval of the client’s family law attorney.
We will explore methods of altering the client’s estate plan without violating automatic temporary restraining orders (ATROs) to best reflect their testamentary desires. Further, we will discuss common automatic revocations in the event the client fails to change testamentary provisions (will, trust, beneficiaries, title) after the divorce is final.
From Family Court to Probate Court
The family law court has jurisdiction over the division of assets pursuant to a divorce. The death of a spouse during the divorce process moves the jurisdiction from family court to probate court. If property is held in joint tenancy, the survivor inherits the spouse’s interest. If “I love you” wills are in place, the surviving spouse will receive all the decedent’s assets. These consequences are most assuredly contrary to the new reality of each partner wanting their share (or more) of the marital assets during life and, if they think about it, they want testamentary control. If possible, the client wants to redirect property to anyone but their soon-to-be ex-spouse.
Our discussion assumes that only one spouse is your client, such as a new client engaged during the divorce process. If you have an existing client couple who are divorcing, then the planner sits in a position of conflict and cannot give advice to one spouse that could be detrimental to the other. The planner should consider telling them both, with identical language, that their estate plan is now probably obsolete and that there may be certain estate planning actions that should be independently discussed with each party’s family law and/or estate attorney.
As we will see, a number of estate planning techniques can be employed. Which, if any of them, do we want to employ? Because the client is already paying significant legal fees, they are often reluctant to incur attorney fees for estate planning. We need to go through a cost-benefit-risk analysis with the client. Does the client have health risk factors? Does the client’s spouse have health issues? How adamant is the client about protecting their share in the event of premature death? What is the cost of creating new estate documents, changing titles, etc.?
For a healthy couple in their 30s or 40s, the risk of death may be very small. For couples in their 60s, 70s, or 80s, the risk is significantly higher, and if you throw in known health issues, a call to action may be paramount. Some strategies cost little and are easy to implement, such as breaking a joint tenancy. Others, such as a new pour-over will with an unfunded revocable living trust, are more costly.
The planner should look at a marital balance sheet that lists all the assets and liabilities, consider how title is held or who are the stated beneficiaries, and ask a few questions:
- If my client dies before the property settlement has been executed, how will my client’s share of each asset be distributed? How does my client feel about that?
- If my client’s spouse dies before the property settlement has been executed, how will each asset be distributed?
- What are the ages and health issues of each spouse? If a suggested technique were employed, would that likely benefit or harm my client’s potential financial settlement?
If your client is healthy and their spouse has significant health issues, you might suggest they do nothing. If your client is the husband, you might suggest changes to ensure his testamentary desires are provided for.
Working with Restraining Orders
Once divorce proceedings have begun, i.e., one spouse has been served a summons, nearly all financial dealings are now under the purview of the court. This comes with specific provisions that are commonly referred to as automatic temporary restraining orders, or ATROs. Our estate planning discussion is incumbent on knowing and navigating the ATROs in the client’s resident state. What a client cannot do (prohibitions), can do, and should do provides the framework of estate planning during the divorce process.
Cannot Do
Most states have ATROs, and it is beyond the scope of this article to enumerate which states do, which don’t, and the differences among the states. It is incumbent upon the planner to review the application of these principals in the client’s state. ATROs apply to all property, both community property and separate property. All assets are considered marital property until the court rules otherwise. Hence, a spouse cannot freely control a separate property asset without permission from the family court judge or acquiescence by the opposing spouse.
Openly discussing ATROs is a great client service. Their attorney has likely discussed these prohibitions and provided written instructions, but the client often walks out of the attorney’s office in a highly emotional state and fails to understand or grasp the severity of the rules. We can assist a client in avoiding mistakes (risk management), and the planner’s knowledge of the rules can also protect against a malpractice suit. (See Example 1.)
ATROs are automatic, as the “A” implies. It is not an order issued by a judge restraining one party from some certain action. These restraining orders are automatic once the divorce proceeding begins, and they apply to both spouses. They are espoused in a state’s family law code, and the word “restrain” should be interpreted as a prohibition. California Family Code Section 2040(a)(2) states that a divorce summons contains a temporary restraining order:
“Restraining both parties from transferring, encumbering, hypothecating, concealing, or in any way disposing of any property . . . without the written consent of the other party or an order of the court . . . [Emphasis added].”
Here is a list of other financial activities commonly prohibited by ATROs:
- Cashing out a life insurance policy
- Borrowing against a life insurance policy
- Transferring a life insurance policy
- Disposing of life, health, automobile, or disability policy
- Creating or modifying a nonprobate transfer
The first four are self-explanatory, but the fifth deserves further discussion. Nonprobate transfers include things like payable- or transferable-on-death accounts, beneficiaries of annuities and life insurance policies, creating new joint tenancies, and trust arrangements. The husband, for example, cannot remove his wife as beneficiary and replace her with his adult child (or his girlfriend!). Also, he cannot create and fund a trust during the divorce process that leaves his assets to his children, thereby cutting out his wife. Likewise, he cannot buy property in joint tenancy with his brother.
While we have discussed the common prohibited transactions, any of these actions are permissible with written consent of the other party or by order of the court. However, seldom does a spouse accommodate any financial changes that the divorcing spouse wants to make, and such a request is frequently blocked by the representing attorney.
Can Do
Many states’ family law code sections do not specifically describe what estate planning is permissible and, therefore, one must rely on case law. Especially in these states, the planner must work with the family law attorney to determine what is allowed. California Family Code Section 2040(b) specifically allows divorcing clients to:
Create, modify, or revoke a will. The client can revoke their existing will, which probably states all their assets go to the surviving spouse. Consider executing a new will that reflects your client’s new reality.
Revoke a nonprobate transfer, including a revocable trust. While the client is prohibited from creating or modifying an existing nonprobate transfer (see earlier discussion), they can revoke a nonprobate transfer. Notice of the change must be filed with the court and served to the other party. The existing revocable living trust may provide that the surviving spouse inherits all the decedent’s assets or provides lifetime income. When divorce proceedings start, your client likely wants to direct their share of the assets to a different beneficiary.
Eliminate a right of survivorship to property. Either spouse has the right to change title from joint tenancy with a right of survivorship (JTWROS) to tenants-in-common. Upon death, the property would not pass by title; rather it would be directed by the person’s will or another testamentary device.
Create an unfunded revocable or irrevocable trust. Remember, we are prohibited from creating a nonprobate transfer. If the trust has not been funded, then it will take a probate transfer to fund this trust. The family law code wants some court oversight, whether it be family law court or the probate court, for testamentary transfers to ensure the surviving spouse can make a rightful claim as to their interest in marital properties. Having a pour-over will paired with an unfunded revocable living trust could be a great solution.
Execute a qualified disclaimer. If a person has the right to inherit property, which would be separate property, they can still disclaim it. By the nature of a disclaimer, they cannot direct that disclaimed property; it must follow the direction of the instrument (will or trust) or, if none provided, the laws of intestacy.
Bifurcation is another technique to be considered, which means terminating marital status (legally divorced) while reserving the property settlement issues in family court. If a person is not divorced, the division of assets occurs in probate court. If a revocable living trust is in place, then the division is in accordance with the trust document. By terminating the marriage via bifurcation and reserving the property settlement, division of assets will remain in family court. Death will not move the decedent’s assets into probate court. Joint tenancies will not pass the property to the survivor. Many beneficiary designations will be considered null. All of this will be meted out in family court. The executor now represents the interests of the deceased former spouse. The automatic revocations (discussed later) come into effect because the deceased is not married. The key point is that the provisions of the testamentary documents (wills and revocable trusts) are ignored, and the property division remains under the family court’s jurisdiction.
A detailed discussion on bifurcation is beyond the scope of this article and should be employed after discussion with the client’s family law attorney and an analysis of resultant financial implications. However, bifurcation can be a significant tool in protecting against the unintended consequences of a premature death.
Bifurcation also reserves the right for the deceased spouse’s estate to get reimbursed for separate property contribution to jointly owned property. To illustrate this “right of reimbursement,” the married couple buys a house, and the wife uses her separate property to make the down payment. During divorce, she is first entitled to reimbursement for her down payment and the remaining equity is split 50–50. By contrast, death during divorce moves the asset division to probate court where 100 percent of the house may go to the husband, contrary to the wife’s current wishes. Bifurcation, however, reserves this right for the wife’s estate.
Should Do
Does the client want their divorcing spouse to have the power to make health decisions in the event of incapacity? Likewise, does the client want their divorcing spouse to be able to make financial decisions on their behalf? Usually, the answer to both questions is “no.” The client should strongly consider updating their healthcare directive and financial power of attorney. Assigning agents (healthcare proxy and power of attorney) is not prohibited by the ATROs. The client is often resistant to incurring additional legal fees, but I hesitate to recommend do-it-yourself (online) documents. The client must weigh the risk of DIY (no professional oversight) versus old documents that allow the opposing spouse to retain these powers. There are state-specific resources, such as AARP, for online healthcare directives. Simply stated, removing the spouse as an agent on these documents is a “should do.”
Automatic Revocations
Let’s assume both spouses survive the divorce and they have not made any changes to their estate documents. Very few clients are going to rush to the estate attorney the day after their divorce goes final. What happens if an ex-wife dies and her documents still provide for her ex-husband? Twenty-nine states provide automatic revocations as to any estate, title, and beneficiary designations that would otherwise go to the ex-spouse. For example, California Probate Code Section 6122 states that a marital dissolution or annulment revokes appointment of property, conferring general or special powers of appointment, nomination as executor or trustee, and joint tenancies.
A very notable exception is an ERISA account. In Egelhoff v. Egelhoff, 532 U.S. 141 (2001), the U.S. Supreme Court ruled that ERISA, being a federal law, trumps state law. A state law may declare that the beneficiary designation is automatically revoked for retirement accounts, but if it is an ERISA account, the stated beneficiary will inherit the property. Therefore, it is imperative that, as soon as practicable, a client with an ERISA account should replace the ex-spouse with new beneficiary designations.
We note that 29 states have automatic revocations. First, that leaves 21 states where beneficiary designations and title on property may need to be changed. Second, for those states with automatic revocations, each state creates its own rules. Life insurance beneficiaries may be subject to automatic revocations in one state, but not another. The planner should be diligent in having the client update all beneficiary designations and encourage the client to obtain new, updated estate documents.
Practical Examples and Applications
The following identifies common issues and opportunities in the estate planning space.
Example 1
Wife has a $500,000 IRA that the husband managed. She becomes your new client during divorce, and she transfers the account over which you have discretion. You discover it holds only three single stock positions. You have a fiduciary duty to diversify, so you sell those positions and create a 40–60 diversified portfolio using mutual funds. During the divorce proceedings, the former equity positions would have appreciated by 30 percent while the diversified portfolio appreciates by 2 percent. Client’s husband claims you violated the ATRO by selling marital assets without his permission. This damaged the marital estate, and the wife (or you!) should reimburse the marital estate for the full gain that otherwise would have been achieved. You unwittingly caused your client to violate the ATRO. You may be responsible for making the marital estate whole.
Example 2
Wife has a $500,000 IRA and her husband is the beneficiary. She wants as much as possible allocated to her children. While she cannot change beneficiaries, she can remove the husband and leave the beneficiary designation blank. She revokes her will and creates a new will giving all her assets to their children. If she dies before the divorce is final, the probate court will determine who receives the assets. She has prevented her husband from receiving 100 percent, and it would be incumbent on the husband to assert rights over marital property in probate court, a much higher hurdle than being an IRA beneficiary.
Example 3
Husband and wife have a revocable living trust with the provision that, upon first-to-die, the decedent’s share is allocated 100 percent to the survivor. Divorcing wife has significant health issues, and she wants her share to go directly to her children. Wife revokes the existing trust and creates a new will that appoints her assets to her children. Probate court will determine the heirs, not the trust document and not family court.
Example 4
Same as Example 3 except we have a high-net-worth couple. Wife revokes the existing joint trust and executes a pour-over will with a new unfunded revocable living trust. If she dies during the divorce proceedings, her assets will be probated. Assuming they survive any probate challenges by her husband, her assets will fund her new trust. If she doesn’t die and the divorce goes final, she can fund her trust with the marital assets allocated to her.
Example 5
Married couple owns virtually all their assets in joint tenancy (residence, rental property, brokerage account). Husband has a known heart condition and the stress of divorce isn’t helping. Husband changes title to all their holdings to tenants-in-common and drafts a will that gives his assets to his children. If he dies during the process, husband’s share of assets will go to his children, not his wife.
Example 6
Married couple owns their personal residence jointly (JTWROS). Wife inherits money and uses $200,000 to remodel their home. Two years later, divorce proceedings begin. Property settlement is protracted, and wife wants to protect her $200,000 separate property interest. If she dies before the divorce is final, husband will get 100 percent. Wife files for bifurcation ending the marriage while reserving the property settlement issues. If wife dies, the property settlement stays in family court and her executor asserts her separate property interest and her estate gets reimbursed $200,000 before the remaining equity is split 50–50.
Example 7
Husband and wife have “I love you” wills where the survivor inherits 100 percent of the decedent’s assets. Husband revokes his will and creates a new one to ensure that his share goes to his intended beneficiaries (e.g., his children) and not to his divorcing wife.
Example 8
Divorce proceedings are ongoing and husband stands to inherit substantial assets from his mother. While the inherited assets are his separate property, the income from the property will cause him to pay more in alimony and child support, which infuriates him. He disclaims those assets, which now pass to his two adult children from a prior marriage. He has an unenforceable understanding with his children that they will annually gift him an amount equal to the gift tax exclusion.
Post-Divorce Actions
Once the divorce is final, the financial planner should not rely on the automatic revocations. First, triage the planning actions. As previously discussed, ERISA beneficiaries should be immediately addressed. Change title to the assets allocated to the client. Create an asset transfer schedule documenting property allocated to your client (e.g., portion of former spouse’s IRA to be transferred to your client’s IRA account), track all transfers, and confirm that the new titles are correct. Have the client engage an attorney to draft new estate documents. Check all beneficiary designations (IRAs, life insurance, TOD accounts, annuities).
The goal of estate planning is to transfer assets to the intended beneficiaries. If death occurs during the divorce proceedings, a divorcing spouse would likely be an unintended beneficiary. Consider the ages and health conditions of each spouse. Examine the marital balance sheet and determine how assets would flow from a death before the divorce is final, with an eye to your client’s desires.
The financial planner needs to review the ATROs that apply. Read the law and consult with a family law attorney for clarification.
If your client is the one initiating the divorce, the client should consult with a family law attorney before divorce proceedings start. Consider proactively executing a new healthcare directive, financial power of attorney, and changing beneficiaries on financial accounts. Discuss the array of options, as well as plan for steps to be taken once the court has jurisdiction, such as breaking joint tenancies.
The planner does not have to be a divorce planning expert to recognize these issues. Discuss these ideas with the client, bring the family law attorney into the process, and then the estate attorney if warranted. The financial planner can make a significant contribution to the client experience by examining the estate planning issues before, during, and after divorce.
