Ute Scott-Smith, ChFC, CDFA
Guiding You through Divorce
to Financial Security
Common Costly Divorce Settlement Mistakes
Divorce is an emotional crisis, but it need not be a financial disaster. The key is to get financial divorce advice so you will understand what is best for you in the long run and not do what seems easiest in the short term. You are about to make financial decisions that will affect the rest of your life. Therefore, unforeseen consequences of a mistake in your divorce settlement can take several years to become evident. But when it does, it is real.
Mistake #1 - The House
Trading their share of a spouse’s pension for the marital home is one of the most common and potentially most damaging mistakes divorcing people make. The marital home and the retirement plans are likely to be the largest assets in your marriage. Many people have such an emotional attachment to their home that they cannot fathom life in another house. The house, though, usually comes with high mortgage payments, maintenance and repair bills that can devastate a person’s finances. Even though the value of the house might be equal to the value of the pension at the time the divorce settlement is written, they are apples and oranges. A house requires income to pay for repairs, maintenance, improvements, property taxes, and assessments; a pension, however, produces income without costing income. A 50/50 division of assets may sound equal, and it may in fact be equal in value as of the date of divorce, but it may not meet your long-term needs. You cannot sell a windowpane to put food on your table during your retirement years. It’s not how many assets you have – it’s what you can do with the value of those assets that matters most.
Mistake #2 - Future Expenses versus Net-Income
Once your divorce settlement is final, you may be receiving different types of income – employment earnings, spousal support (also referred to as spousal maintenance or alimony), or perhaps child support – some of which will probably be taxable. In the midst of support negotiations, you need to know how much you’ll actually be left with each month to understand the impact of a proposed divorce settlement. To figure this out, you first need to separate the taxable and tax-free income amounts you will be receiving. Total all your taxable income, estimate and subtract the tax payable, and then add the tax-free income amount to the after-tax figure. Be aware that additional taxable income may move you to a different tax bracket, so be mindful of the tax rate you use. Compare your after-tax income to your expenses to create your new budget. Far too often, estimates of future living expenses are not accurate. Far too often, estimates of future expenses are just too low. Calculating your net disposal income is critical to helping you budget and to understand your new financial reality after divorce.
Mistake #3 - Impact of Taxes on Assets
Tax issues surrounding the financial aspects of a divorce settlement are often misunderstood or overlooked. The areas most likely to be of concern are income taxes, capital gains taxes, and the effects of alimony.
Capital gains taxes may influence the disposition of the house which is subject to a capital gains exemption under proper circumstances. Lack of good planning regarding exactly how and when it is sold could result in a costly mistake. If capital gains had been rolled into the marital home from other house(s) owned before 1997, old tax rules will apply to determine the cost basis of the current house.
Potential tax obligations due on investments upon future sale will impact their current value to each of you. For instance, two brokerage accounts having the same monetary balance of $300,000 may not have the same real value if one of them has potential capital gains taxes, which will reduce its net assessment, and the other does not.
Retirement accounts present complex tax considerations with some special exceptions for circumstances of divorce. Funds which are generally not available without penalty, may be accessible within certain limits and procedures.
Contact us today for complimentary divorce advice and learn to avoid your potential costly mistakes!
Ute Scott-Smith
ChFC, CDFA