As you consider your divorce settlement, you may be tempted
to sign it just to get things over and done with. This is a
bad mistake. Even if everything looks fair and equitable, you
may not really be getting a good deal. Below is an article by
By William Donaldson, that outlines some major areas to consider
in your divorce negotiations.
Divorce and Your Finances -
The 7 Most Costly Settlement Mistakes
Each year there are nearly 1 million divorces in the United
States, or about 50% of all marriages (2002 United States Census
Bureau statistics). 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
Mistake #1: Not Knowing the Liquidity
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
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.
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
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
· 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
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
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
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 or forensic accountant.
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
A Certified Divorce Financial AnalystTM (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!