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Articles >
Taxation > Article |
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Divorce and Your Finances – The 7 Most Costly Mistakes |
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By William Donaldson, CFP, CDFA and Adam Westphalen,
CFP, CDFA |
 Each
year there are nearly 1 million divorces in the United States, or about
50% of all marriages1. The real tragedy, however, is the financial
devastation that occurs to many individuals after their divorce.
Too often, a divorcing individual accepts an unfair settlement and finds
that a few years later he or she is experiencing serious financial
challenges. Was he or she intimidated or pressured to settle? Did the
offer appear to be equitable? What ever the reason, this outcome can be
significantly improved upon, if not altogether avoided, if you first
understand the seven most costly financial mistakes commonly made in
divorce settlements.
Following are brief summaries of these seven mistakes. Each of these
areas can be quite complex, so we strongly recommend that you consult a
professional prior to making a financial decision that may affect the
rest of your life.
This list is not exhaustive, and depending on the complexity of your
case, there may be many more areas that require thorough analysis.
Mistake #1: Not Knowing the Liquidity of Assets
Liquidity refers to the ability to access the cash value of an asset. For
example, a bank savings account is highly liquid, because you can simply
withdraw funds from an ATM when you need them. An antique automobile,
however, is nearly illiquid because it is very difficult to quickly sell
this asset to access the actual cash value.
Often in a divorce settlement, one party will receive mostly illiquid
assets, including the home, while the other party receives liquid assets
such as retirement plans, brokerage accounts etc.
What is the potential problem with this type of settlement?
On the surface, this scenario may appear to be equitable assuming that
the home and other assets are of approximately the same value. However,
the challenge lies in cash flow. How will the party that keeps the home
pay the bills if his or her major asset is illiquid?
One can borrow against the equity of the home, but that’s costly (closing
costs, interest etc.) and it takes time to close the loan. In worst-case
scenarios, the home must be sold, a smaller home is purchased and the
remaining equity is utilized for living expenses.
If your proposed financial settlement has very little liquidity, be sure
that you will have enough cash flow throughout the years to handle your
living expenses. If not, you may have to consider selling the home, other
assets or significantly decrease your expenses in order to meet your
budgetary needs.
________________________________
1 2002 United States Census Bureau statistics
Mistake #2: Failure to Consider the Impact of Taxes
The effect of your settlement on various taxes can be very costly if not
addressed thoroughly. Capital gains, income tax, and alimony are just a
few of the areas that may be impacted.
Capital gains taxes need to be analyzed when property is being divided.
Capital gains refer to the fair market value of an asset minus its cost.
For example, if you paid $5 for a share of stock and it is now worth $25,
you have a capital gain of $20. This applies to other assets such as real
estate (including your home), mutual fund accounts and just about any
investment that has appreciated in value.
Be very careful that the property you are receiving in a settlement does
not have large capital gains as compared with your ex-spouse’s property.
Don’t be fooled if your spouse offers you property of equal value but
conveniently forgets to inform you of the tax liability.
As an example, you may be offered an investment account worth $150,000,
but the cost basis is only $50,000. That means there is a gain of
$100,000 that you must pay at minimum long-term capital gains tax (15% in
2004). There could possibly be short-term gains as well, which are taxed
at your own marginal tax rate (as high as 35% in 2004).
In the case of your personal residence, the federal government eased the
tax burden in 1997 by allowing a $250,000 capital gain exclusion per
spouse if you’ve lived in your home for at least 2 of the past 5 years.
If the home is to be sold and there is a considerable gain in value (over
$250,000), you should consider selling before the divorce to take
advantage of the full $500,000 exemption.
If you had sold a home prior to 1997 and rolled over the capital gain to
the existing home, the old rules will apply to determine the cost basis
of the current home. This will increase your gain and possibly further
the need to sell while still married.
Income taxes are effected primarily by alimony payments and filing
status. Alimony received is taxable as ordinary income, so a $50,000
payment received is actually worth $35,000 after
taxes, assuming a 30% marginal state and federal tax bracket.
On the other hand, the payer of alimony receives a tax deduction, so the
same $50,000 payment actually costs the taxpayer $35,000 assuming the
same tax bracket.
Filing status is an important decision after the divorce. If you were
still married on 12/31 of the tax year, you have the option of filing a
joint return. If you can peacefully deal with your spouse after the
divorce, you should consider this option as it could save considerable
tax for both parties.
If you were divorced after 12/31 and you qualify, filing as head of
household versus single can also save considerable tax dollars. Your best
course of action is to consult with a tax professional regarding these
options.
Mistake #3: Not Understanding the Rules of Retirement Accounts
Retirement accounts are a tax related issue, but their complexity merits
a separate category. If a large portion of your settlement consists of
retirement assets, you need to be aware of the many tax ramifications and
potential penalties involved.
Normally, distributions from a retirement plan prior to age 591/2 are
considered “early distributions” and are subject to a 10% penalty tax as
well as ordinary income tax. An exception to this rule, however, is a
transfer to an ex-spouse as part of a divorce settlement. A Qualified
Domestic Relations Order (QDRO) is used to affect this transfer. Income
taxes still apply, so any assets you receive from a “qualified plan”,
such as a 401(k), will be subject to a mandatory 20% tax withholding. For
example, if you are awarded a $100,000 distribution from an ex-spouses
401(k) you will actually receive only $80,000.
To avoid this mandatory withholding, the transfer must be made directly
to another retirement account, such as your own IRA. Once the assets are
in your retirement account, you are now subject to the early distribution
rules. If you need some of the assets to live on, or pay bills, make sure
you take them out prior to transferring them to an IRA to avoid the 10%
penalty.
To simplify, let’s look at an actual example of how this transfer works:
Barbara and Stanley are both age 55 and going through a divorce. Stanley
has $560,000 in his 401(k) that will be divided by a QDRO, transferring
$280,000 to Barbara.
She could transfer the money directly to her IRA and pay no taxes until
she starts withdrawing funds after age 591/2, at which time she would pay
ordinary income tax on the amount withdrawn. But Barbara needs $80,000
for a down payment on a new house. So she holds back $100,000 before
transferring the remaining amount to her IRA. 20% is withheld for taxes,
leaving her with $80,000 to spend without incurring a 10% penalty.
After she transfers the remaining $180,000 to her IRA, Barbara is held to
the early withdrawal rule. If she says, “Oh, I forgot, I need another
$10,000 to buy a car,” it is too late. She will have to pay the 10%
penalty and the taxes on that money.
It is important to note that IRA’s are not qualified plans, so a QDRO is
not needed to divide the assets. Also, there is no 20% mandatory tax
withholding on a transfer. To avoid paying taxes, you must deposit any
distribution from an IRA directly to your own IRA. If a check is sent to
you, you must deposit the money into your own IRA within 60 days to avoid
a taxable distribution.
Mistake #4: Overlooking Debt and Credit Rating Issues
Nothing is worse than starting out a new life with bad credit. Several
steps can be taken during the divorce process to minimize the chances of
this occurring.
First, obtain a copy of your credit report. This will identify all joint
accounts, accounts you may not have been aware of, and any potential
credit problems.
Next, be sure to pay off and close all joint accounts prior to the
divorce settlement and open new accounts in your own name. Unfortunately,
creditors don’t care how a separation agreement divides responsibility
for joint debt (joint credit cards, auto loans etc.). Each person is
liable for the full amount of debt until the balance is paid, hence the
importance of dealing with this issue prior to your divorce.
Regarding income tax debt, even if the divorce is final, you may not be
exempt from future tax liability. For three years after the divorce, the
IRS can perform a random audit of a divorced couple’s joint tax return.
If it has good cause, the IRS can question a joint return for seven
years.
To avoid any potential problems down the road, your divorce agreement
should have provisions that spell out what happens if any additional
penalties, interest or taxes are found as well as where the funds come
from to pay for any expenses associated with an audit.
Mistake #5: Not Maintaining Control Over Insurance Policies
Most divorce decrees call for one of the parties to obtain a life
insurance policy to insure the value of alimony payments, child support
or some other financial need. If you are the person for whom the
insurance is obtained, it is critical that you are either the owner or
irrevocable beneficiary of the policy.
If you are not, the ex-spouse who took out the policy could easily stop
making payments and you would never know about it until the policy is
needed and it no longer exists. This could be financially devastating. As
the owner or irrevocable beneficiary, you would be notified of any
outstanding issues with the policy, such as non-payment of the premium,
and could therefore take action and prevent the policy from lapsing or
being cancelled.
Mistake #6: Failure to Budget
One of the most common mistakes made post-divorce is the failure to
budget based on one’s new lifestyle. We see this happen most often when
one spouse keeps the home for the sake of the children or perhaps due to
an emotional attachment. Because of the high value of the home, there are
few other assets awarded in the settlement. The expense of maintaining
the home and the lack of liquid assets often results in a rapid depletion
of cash, leaving no choice but to sell the home.
This scenario can be avoided if you take a good hard look at your
expenses versus liquid assets and income. A Certified Divorce Financial
Analyst can help you project several years into the future and determine
if you’ll have enough resources to support your current lifestyle as well
as your retirement years.
This analysis should be completed prior to a settlement. If it is
determined that you will be unable to maintain your lifestyle with the
proposed offer, you have established a good case to request more assets,
alimony or child support.
Mistake #7: Failure to Identify Hidden Assets
Hopefully, you’re not in a situation where you distrust your spouse and
fear there are hidden assets that should be included in the settlement.
Unfortunately, once a divorce is initiated, many individuals will do
whatever they can to preserve what they feel is their own money. Some
individuals maintain secret accounts or other financial activities
throughout an entire marriage. If these assets are not exposed, one
spouse is certain to obtain an unfair settlement.
There are multiple resources and methods used by financial professionals
and attorneys to uncover potential hidden assets. Being aware of these
may help you avoid being victimized by a dishonest spouse. Forensic
accountants are generally the most commonly utilized professionals to
assist in this area.
Tax returns are one of the best places to start. Most people are uneasy
about misleading the IRS for fear of penalties, fines and even prison. Go
back at least 5 years to look for any inconsistencies in income, the
presence of trusts, partnerships or real estate holdings.
If your spouse is a business owner, corporate or partnership returns may
show a change in salary, charging personal expenses to the company, or
excessive retained earnings. Another common trick is to put a “friend” on
the payroll, who agrees to give back the money paid to him after the
divorce. A forensic tax professional is of tremendous help in this area.
Checking account statements and cancelled checks for the past few years
can also be quite revealing. A cancelled check for a purchase you never
knew about, such as an investment property, can make a substantial
difference in total assets to be divided.
Savings accounts may reveal unusual deposits or withdrawals in amount or
pattern that could point to a hidden asset such as a dividend producing
investment. In addition, cash may be hidden almost anywhere.
Brokerage statements are valuable in tracking the purchase and sale of
securities. If securities are sold and the proceeds are not accounted
for, you can be sure that the assets are out there somewhere.
Expense accounts can be abused when corporations give employees a great
deal of leeway in their expense account reporting. Cross checking between
expense account disbursements and savings/checking account deposits may
indicate a pattern of abuse if the deposits exceed legitimate business
expenditures.
Children’s bank accounts may be opened as a custodial account for the
intent of hiding assets as well. In some of these cases, interest is not
reported as income on tax returns, and no return is filed for the
children.
This is not an exhaustive list of places to look for hidden assets. If
you suspect this is occurring, you owe it to yourself to seek help from a
financial professional.
In Summary
There are thousands of articles, books, manuals and other publications
written about the financial issues of divorce. It is a complex area, and
certainly deserves the attention it gets.
But reading this article or any other resource will probably not make you
an expert. If you think you may not be receiving fair treatment, or you
are simply uncomfortable dealing with these issues, it might make sense
for you to consult with a financial professional who is trained
specifically in divorce related issues.
A Certified Divorce Financial Analyst (CDFA) has endured extensive
training in the financial issues of divorce. He or she will analyze the
long-term financial impact of a proposed settlement and help you
determine if it is feasible. Remember that a proposed settlement might
look fair initially, but without proper analysis and forward looking
projections, it can lead you to a future of financial hardship.
The bottom line is don’t settle until you know how it will affect your
financial future! |
 Explore
tax planning for my family |
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William Donaldson and Adam Westphalen are Certified
Financial Planner professionals and Certified Divorce Financial Analysts.
They are the founding partners of The Vista Companies; a group of firms that
together provide comprehensive, full service financial management to a
variety of clients across the country. They specialize in working with
divorcing couples or individuals, helping them both pre and post divorce
with all aspects of financial planning. For more information about their
services, they can be reached toll-free at 866-23-VISTA or on the web at
www.MyDivorceSupport.com and www.Vista-Financial.com.
CFP, CERTIFIED FINANCIAL PLANNER™ and federally registered CFP (with flame
logo) are certification marks owned by Certified Financial Planner Board of
Standards Inc. These marks are awarded to individuals who successfully
complete CFP Board's initial and ongoing certification requirements. |
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Divorce and Your Finances – The 7 Most Costly Mistakes |
| Each
year there are nearly 1 million divorces in the United States, or about
50% of all marriages1. The real tragedy, however, is the financial
devastation that occurs to many individuals after their divorce. |
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