Negotiating your separation agreement can be one of the most trying, costly, and long-lasting events in your lifetime. Just like our transition to springtime, a change in attitude and mindset can enhance your chances of a faster and financially positive divorce settlement.
To be better informed and able to make the tough decisions that come along in the process, take a step back and avoid these common mistakes.
1. Assuming your divorce will be fast and not costly
Depending upon your selection of a divorce attorney or mediator, the amount of assets at stake, the amiability of the partners, etc., your divorce can cost more money and take longer to settle than you may think. For most couples, the whole process can take one to two years. The cost can range from several hundred dollars to several thousand, even if you do not go to court (which can cost at least $25,000 plus for each spouse).
At first blush, splitting the family financial pie would appear to be a fairly simple task. An equitable property division, consistent with the respective spouse's divorce rights would lead you to believe that each partner would walk away with half of what was shared by two.
This mathematical formula does not consistently work in divorce. Spouses have unequal salaries and income potential. Many times, families live beyond their means; there may not be enough money to go around. These factors, along with the typical "hanging on to each dollar" can lengthen the process, which leads to additional time and mounting costs.
2. Selling out your future
Your final decisions concerning which assets you are keeping will have an impact on your immediate future and long-term goals. What are the hidden expenses (maintenance, income taxes, etc.) of the assets you may want? Will you have enough money to pay your bills? What financial assets will you have to face unexpected costs and meet long-term goals (e.g. college costs, retirement, etc.)?
Trading away long-term options (e.g. retirement accounts) for short-term needs (desires) may not be in your best interest and may lead you to sacrifice tomorrow for what you may want today.
3. Ignoring Income Taxes
Income taxes will affect most of the major financial aspects of the divorce settlement. Generally speaking, the transfer of property pursuant to a divorce is a nontaxable event. But that changes if you subsequently sell the property. At that time, you will be solely responsible for paying the tax on all of the gain (profit) earned from the time you and your spouse originally purchased it.
Consider carefully how you will file you tax returns while you are in the process of creating a separation agreement. Although there are non-financial considerations, the Married Filing Separate filing status normally yields the highest overall tax rate. Filing Head of Household normally produces the least amount of tax.
You will also want to review the tax implications of alimony and child support, dependency exemptions, and various tax credits that are associated with the custody of the child.
4. Not protecting your financial interests
Maybe you have been married for 10, 15, 20 years or more. It is difficult to think about separate accounts or removing your spouse's name from charge cards. The reality is that you are at risk any time you hold a joint interest in, or have responsibility with, or are financially dependent upon your ex-spouse.
What happens in the future if your former spouse defaults on payments becomes disabled, goes bankrupt, or dies? You should consider these possibilities that could have a significant impact on your financial position and take appropriate measures to protect your interest (and that of your children).
5. Not recognizing "A bird in hand..."
You may have to weigh decisions like this: What do you want, the Lexus worth $35,000 or the mutual fund worth $30,000? Do you want lifetime payments that begin at age 65 (or if and when your spouse retires) or $300,000 today?
Keep the phase in mind, "a bird in the hand is worth two in the bush." In divorce situations, this axiom usually holds true. Let's take a look at the Lexus. Sure it may be worth $35,000 now, but what will it be worth next year? If you really need cash, how much could it be sold for? The mutual fund is liquid now, will most likely increase in value, and provides a cushion for those unexpected expenses.
What about retirement income? It sounds secure, but you may have to wait 20 or 30 years to receive the payments. It may be wiser to take the cash now, make prudent investment decisions, and build your own retirement nest egg.
In my experience, it is difficult for divorcing partners to see beyond the day in front of them. Avoiding these mistakes by obtaining the divorce advice of a Certified Divorce Financial Analyst can help you maintain your financial status and minimize the risk of financial loss.
Sound divorce advice is particularly critical when it comes to splitting the retirement plans. This article shows how one or both spouses can avoid the 10% early withdrawal penalty.
Many spouses caught in the trauma of the divorce settlement process face the same problem. They have a need for cash but 100% of the savings is in retirement. One or both may have significant retirement accounts with their employer, but believe that these funds are not available to them without the IRS 10% penalty tax.
Most times, it is not sound financial planning to liquidate all or part of your retirement funds for purposes other than retirement; however, this may be the only source of cash available to maintain one’s standard of living.
Under a special section of the Internal Revenue Code (72(t)(2)(c), an alternative payee (i.e. the non-employee spouse) can take cash from a Qualified Plan (such as a 401k), without the 10% penalty, even if they are under age 59½. To avoid the penalty, the following criteria must be met:
- The retirement plan must be a qualified plan covered by ERISA (e.g. 401K and Defined Contribution Plans);
- The funds must be paid to an alternative payee, not the owner of the account; and
- A Qualified Domestic Relations Order (QDRO) must be created and used to divide the plan
The amount paid is taxable income to the alternate payee and the employer will withhold 20% of the distribution to prepay the tax. So whatever non-employee’s cash need is, the 20% withholding should be taken into account when asking for a withdrawal. If the spouse who is entitled to the distribution does not need all of the cash, part could be paid in cash and part could be transferred to that spouse’s IRA. There will not be a 10% early distribution penalty on the cash paid out or the transfer.
Let’s look at an example.
Fred and Ginger, age 45, are getting divorced. As part of the settlement agreement, Ginger is entitled to 50% of Fred’s 401K containing $400,000. Ginger needs cash of $100,000 to establish an emergency fund and pay some outstanding bills. Their attorney creates a QDRO that directs Fred’s employer to assign funds totaling $200,000 to Ginger. The Order further stipulates that Fred’s employer to pay Ginger $125,000 in cash, with $25,000 withheld to prepay the Federal income tax (note that Ginger may have to make a State Income Tax estimate also). The balance of $75,000 would be transferred to Ginger’s IRA.
In this transaction, Ginger would receive $100,000 in cash (and taxable income of $125,000) and $75,000 in her IRA, which is nontaxable. There would not be an IRS penalty for this withdrawal and transfer. It is very important to understand the rules of the retirement plan that is involved in this situation. The QDRO will not be effective unless its assignment of rights or division of benefits complies with the terms of the Plan.
One word of caution, this rule does not apply to IRAs. Any premature distribution related to a divorce would be subject to a 10% premature penalty.
What if both spouses needed cash?
This maneuver takes lawyering skill and creativity in drafting the agreement; however, the non-employee spouse could take more cash than needed and give the excess cash to the employee- spouse, possibly as a reimbursement of professional fees.
What if you only have an IRA?
Under code section 72, there is a penalty-free way to access your IRA if you are under age 59½.
In this example, John, age 53, needs additional income to make payments on a second mortgage recently obtained during his marriage. With support, it is extremely difficult to make ends meet. His only savings exists in his IRAs.
John can take a “series of substantially equal periodic payments” from his IRA. Distributions from such an arrangement are exempt from the ten percent penalty that normally applies to distributions taken before reaching age 59½. The flexibility in this arrangement is that the payments must continue for five years or until John reaches age 59½, whichever is later. After that period ends, John can stop taking the payments or take smaller payments. Extreme care must be used in setting up this plan as there are stipulations regarding interest rate assumptions, payment modifications, and investment changes.
You can dramatically improve your chances of starting your new life on sound financial footing if you look beyond the divorce settlement and analyze the impact that your decisions will have on your finances in the short and long-term future.
For example, the decision of who will own and occupy the family home certainly has an emotional impact, especially when you have children in school. But what if the spouse who takes possession cannot afford the house, as a home? Beyond the mortgage, there are many expenses including utilities, gardening, repairs, association fees, and general maintenance. Maybe the house could be held jointly for a number of years and sold once the children have moved beyond the divorce process themselves. What is the income tax effect of the eventual sale?
How will the home ownership affect the occupying spouse's ability to fulfill other family needs such as automobile expenses, food, health care co-pays, school expenses, etc.? There may be other alternatives that could help both spouses financially and at the same time, keep the children "on solid ground."
The long-term financial results of these transactions also need to be analyzed and compared during the divorce process.
In the situation where one spouse has worked at home while the other started and maintained a career, there are "career assets" that can be the most significant assets of the marriage. In addition to salary, there can be a substantial pension or retirement plan. What about stock options, bonuses, and health, life, and disability insurance? Each of these can have a profound impact on how the marital property should be divided and the amount of support that is needed by the work-at-home spouse.
I have outlined below what factors need to be considered when making decisions about the major financial components of the separation and divorce agreement:
- Inflation affects Alimony, Pensions, IRAs, sale of the family home, and the property division
- Investment Rate of Return affects pensions, all retirement plans, and the property division
- Income Taxes affect all the financial aspects
- Special Legal considerations affect child support, pensions, other retirement plans, and the family home sale
- Cash Flow is affected by pensions, all other retirement plans, and the property division
Inflation - Expenses will not remain the same over the next 5 to 10 year time period. It is important that the income you receive matches at least the rate of inflation.
Investment Rate of Return - Assets will grow at different rates of return and have different financial risk. How much return do you need? How much risk can you take?
Income Taxes - Virtually all the financial choices you will make will be affected by income taxes. Can you withdraw the money from a retirement plan without penalty? If the house is sold, will you have to pay income taxes? Will the monthly income you receive be taxable?
Special Legal - Once the Divorce Agreement is finalized, there is sometimes additional paperwork, e.g. a Qualified Domestic Relations Order (QDRO), which has to be completed before you can take possession of an asset. I always recommend that the preparation of the QDRO begin during the divorce negotiations.
Cash Flow - Employer retirement plans may have restrictions on lump sum distributions. IRAs cannot be withdrawn without penalty (under most conditions) prior to age 59½. This is important to know prior to the final settlement, especially if you need the cash to maintain your standard of living.
In many circumstances, there are crucial steps that must be taken in anticipation of a settlement. An example of this is where your spouse will be responsible for paying child support and alimony. Instead of waiting for the final settlement, you should protect this anticipated stream of income by taking out a life insurance policy on your spouse so that you and your family will be protected. You should be the owner and beneficiary of the policy.
Divorce can be emotionally and financially devastating. You can reduce some of the stress associated with the process by gaining an understanding of the financial issues of your divorce and involving a Certified Divorce Financial Analyst (CDFA) to provide a detailed analysis of financial result of your settlement.
Divorce settlement agreements specify who will be claiming the dependency exemption; and that exemption can be released in future years. Some tax breaks, for example the Child Care Credit, belong to the custodial parent even if that parent releases the exemption to the noncustodial parent. But what happens to the parent who pays child support and/or medical expenses and is not entitled to the dependent exemption?
Under an IRS Ruling issued in 2008, there are certain tax benefits that both parents are entitled to, regardless of which parent claims the dependent exemption. Both parents can treat the child as a dependent for the purposes of these tax breaks (for that child):
- Itemized deductions for medical expenses
- Tax-free employer reimbursements for medical expenses
- Tax-free treatment for employee discounts and no-additional-cost services
- Tax-free distributions from medical savings accounts (MSA) when the distribution is used to pay the child's qualified medical expenses
- Tax-free employer provided coverage under a health plan
- Tax-free distributions from health savings accounts (HSA) when the distribution is used to pay the child's qualified medical expenses
This rule only applies to parents who are divorced, legally separated, or live apart at all times during the last six months of the year and the following tests are met:
- Over half of the child's support during the year is provided by the child's parents
- The child is in the custody of one or both parents for more than half the year
- The child is a qualifying child or qualifying relative of one of the parents
In the case where one spouse is in a much higher marginal tax bracket that the other, maybe it would be more tax efficient to reduce child support and let the paying parent be responsible for more medical costs. This may also enable that parent to take advantage of some of the tax exclusions outlined above and produce tax savings that will help both parents’ cash flow.
This ruling further emphasizes the need for divorce financial planning while you are in the process. You may also want a divorce financial planner to review the settlement agreement once it is in draft form.