Written by JSCLG Member Douglas Lyons, CFA®, CFP®
Divorce can be a traumatic experience for many, but by avoiding some common financial mistakes, divorce can be made a little easier. Whether you are using the collaborative process, mediation, or litigation, understanding the following five issues will help you move more confidently into the next stage of your life. Also, assembling a team of advisors, such as an attorney, financial advisor, and/or mental health professional/coach, is critical to helping you understand the challenges and opportunities that lead to a fair settlement.
The first and most pervasive financial issue you need to consider is taxes. Income, capital gains, and estate taxes all may come into play with your divorce and can have a significant impact on your settlement. For example, alimony received is fully taxable, but alimony paid is deductible on the tax return of the payer. In other words, a $100,000 alimony payment would really be $70,000 after-tax to the recipient and a $70,000 cost to the payer (assuming a federal and state marginal tax bracket of 30%). Capital assets such as bonds, stocks and real estate are another asset that may be received in a divorce. The difference between the capital asset’s fair market value and what was originally paid for it (or cost basis) is taxed at the owner’s current (capital gains) rate. A $350,000 investment portfolio may have a cost basis of $50,000 resulting in $300,000 of the portfolio being taxed. A final divorce decree nullifies a pre-divorce Will and potentially subjects you to unwanted and potentially avoidable estate taxes. Beneficiary designations on assets like retirement accounts and /or life insurance policies do not automatically change post divorce. So by not addressing your estate situation an unintended benefit may transfer to an ex-spouse, while that benefit is taxable in the decedent owner’s estate. Consult a tax expert and/or estate attorney before altering your current tax or estate situation.
Retirement accounts can be fraught with potential land mines for the unwary. Retirement assets such as IRAs and/or 401(k)s can be transferred from one spouse to the other as the result of a divorce through a Qualified Domestic Relations Order (QDRO) without immediate tax consequences. If immediate liquidity is needed to support one’s lifestyle then retirement assets may not be the best assets for you. Any withdrawal from these types of retirement accounts will result in income tax at the current owner’s rate (to the extent it exceeds cost basis). If the owner is not yet 59 ½, a withdrawal can result in a pre-mature withdrawal penalty of 10%. So, if the previously mentioned investment portfolio of $350,000 was liquidated from a retirement account (and assuming a zero basis, 30% marginal tax rate, and 10% penalty), you would receive just $210,000, far less than what you may have expected to receive.
Thinking of your house as just another investment will help you achieve a more favorable financial settlement. In the end, you may end up with your current home but hopefully only after realizing that you can afford to stay there. First, you must have the home’s value appraised. Just like a capital asset or retirement asset, you need to next determine the home’s after-tax value. Current tax law allows a single individual to exempt $250,000 of gain before calculating capital gains tax (holding requirements apply). Couples can exempt $500,000 of gain. So depending on the divorce settlement, it may be more advantageous to sell the home prior to finalizing the divorce. If the home has a mortgage, it’s important to have the mortgage refinanced in only the name of the person keeping the home (unless otherwise negotiated). If you disclaim ownership of the home, you will still be liable for the mortgage liability if your spouse doesn’t refinance in just their name.
Next, make sure to consider your risk coverage. This includes life, disability, long-term care, medical, home and auto, and liability insurance. Most likely your coverage for many of these risks was based on joint pricing discounts. Investigate the costs before entering into a settlement. If alimony is being received, requiring life insurance on the spouse paying alimony should be considered to protect the receiving spouse’s lifestyle. As mentioned earlier, also review beneficiary designations of all outstanding life insurance policies. If you are on your spouse’s medical coverage, you may be entitled to continue that coverage through COBRA. While you will be responsible for paying the premium, it may be cheaper and provide better coverage than insurance you could obtain on your own. (COBRA can last for 36 months as a result of divorce.)
Lastly, relying on alimony can be a comforting but potentially ruinous long-term decision. Aside from the stinging reminder of your divorce that alimony brings, it also can erode your lifestyle. (See whitepaper “Inflation & Termites” in publications at Tridentwa.com.) Your ability to live the way you are accustomed to living is eroded each and every year because inflation eats away at the buying power of your fixed alimony payment. Structuring alimony that increases as your lifestyle needs change or receiving a lump sum amount and investing in a diversified portfolio can mitigate the impact of inflation and thereby preserve your lifestyle needs.
Whether you are in the beginning phase of a divorce or your divorce has been finalized, it’s never too late to put your team together to achieve financial security.
Douglas Lyons is a Certified Financial Planner™ (www.cfp.net), Chartered Financial Analyst (www.cfainstitute.org), and member of the Jersey Shore Collaborative Law Group (www.jsclg.org).
Important Disclosures
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