Dividing assets is one of the most difficult things to do when getting a divorce. Having to figure out who gets what can create additional stress, adding to the emotional roller coaster ride you’re already on. And when you’re stressed, it’s easy to make mistakes.
Here are five mistakes people often make, and how you can take steps to avoid them.
Mistake #1: Taking the Short View
In the heat of the moment, it’s easy to say something like, “I’ll figure it out later.” The problem is, there are many ‘now’ decisions that can’t be reversed down the road. Or, if you do try to make a different decision, it’ll cost you a lot of money.
For example, let’s say you and your spouse divide his 401(k) plan. You can have the judge issue a QDRO, or qualified domestic relations order, which tells the 401(k) plan administrator how the assets in the plan will be divided. Usually, the divorcing spouse will roll the 401(k) assets into their own IRA, since this is not taxable. The IRS even allows early distributions from the 401(k) without penalty, pursuant to the QDRO. While you still have to pay ordinary income tax on the distribution, spouses who are under 59 ½ are able to avoid the 10% early withdrawal penalty that the IRS levies on a distribution.
Let’s imagine that you’ve rolled everything into your IRA. If you NOW decide that you need to take some cash out of the IRA for unexpected needs, you now have to pay the income tax plus the 10% early withdrawal penalty, if you’re under 59 ½.
Other common areas where taking the short view can cause long-term damage:
- Not thinking about your health insurance needs
- Keeping the house
- Not paying attention to what your ex might be up to hiding, either on their financial affidavit or your tax return
To avoid these mistakes, you need to think about what life might look like a year from now, 5 years from now, or further down the road. Continuously ask yourself these questions so you can start building your plan to get the right answers. And one of the top priorities is making sure you have cash.
Mistake #2: Not Making Room for Cash (Liquidity)
One of the biggest mistakes a divorcing couple makes is underestimating how much cash they will need after their divorce. After all, an economic benefit of getting married is being able to pool together your resources. When you move in together, you no longer need to maintain two separate residences. You get to share grocery bills, utilities, furniture, etc. And likely, one of you takes the primary responsibility for paying the bills. The longer you are married, the more you get used to this.
When you get divorced, this works in reverse. When you get divorced, each of you has to maintain a separate residence, pay for separate utilities, furniture, etc. Which means that each of you has to be prepared to pay your own bills. If you’re not prepared for it, or if you’re not the one used to paying the bills, you might be in for a shock.
Figuring out what your post-divorce life should look like will take time. And having cash available for unexpected bills, new purchases, and emergencies will help you buy that time until you can sort things out. On the other hand, not having enough cash might cause you to make decisions that make you even worse off.
This leads us to the next big mistake people make.
Mistake #3: Keeping Things You Shouldn’t
Sometimes, it’s difficult to part with things you acquired in a marriage. Perhaps it’s a house, car, or something else of sentimental value. If you’re looking to keep something of significance, you should ask yourself if it will be useful to you in your post-divorce life. More importantly, you should ask yourself, “Is this thing more important than the cash I could currently get by selling it?” If the answer is “No,” then you should look toward giving it to your ex, or selling it.
Sometimes, it’s not this simple. Perhaps you’re both stuck with a house neither of you wants. Maybe you’re in the position of having to keep the furniture for your house because your ex wants nothing to do with it. At this point, you might be better off talking to someone who can help you with the financial aspects of a divorce so you can make the best decision possible.
Mistake #4: Asset Location
When is $1,000 not $1,000. When you’re talking about the difference between $1,000 in a tax-deferred retirement account and $1,000 in cash. In one case, you would have to pay taxes (and possibly an early withdrawal penalty) when you go to actually use the money. In the other case, you don’t.
If you’re not familiar with your investments, it is easy to make a mistake when trying to figure them out. When divvying up your assets, it’s important to know:
- What type of investment you’re dealing with.
- What type of accounts you’re trying to divide.
- Who has ownership of the accounts.
If you’re not very specific on what you’re dealing with, it’s very easy to make a mistake. For example, one spouse could pay significantly more in taxes, even if their divided assets look equal.
Mistake #5: Not Considering Taxes
Taxes should be foremost on everyone’s mind when considering property division. There are two aspects to this:
- Minimizing unnecessary taxes.
- Ensuring an equitable property settlement with respect to tax treatment.
Minimizing unnecessary taxes: Many times, people make a decision that in hindsight, is very tax-inefficient. Had the desired result been known up front, that decision could have been made in a way that lowered or eliminated their tax bill.
For example, let’s say that Jim & Susan divorce. They’ve owned a house for 20 years. Susan wants to live in the house after their divorce until their 13-year old son graduates college. However, they decide that Susan will keep the house, and Jim will receive his ‘share’ in the form of other investments and cash. They draft the divorce settlement to reflect this, and Jim is no longer an owner of the house. Five years later, their son graduates high school and joins the Navy. Susan wants to sell the house, but now there’s a problem. The house, which they bought 23 years ago for $100,000, is now worth $450,000. After minor renovation and real estate agent fees, Susan will still clear $400,000. Susan can exclude up to $250,000 of her $300,000 in capital gains. Had they remained married, they each would have had a $250,000 exclusion, for a total of $500,000. This is a tax exclusion allowed under Internal Revenue Code Section 121-Sale of a Principal Residence.
However, Jim no longer meets the requirements, so Susan can only exclude $250,000. She will owe taxes on the last $50,000 profit, which she cannot exclude, which means she might owe as much as $10,000 in taxes.
Had they recognized this up front and kept Jim as an owner, they would have saved this tax bill. Section 121 also allows for a divorced spouse to use their ex-spouse’s tax exclusion as long as they both remain owners of the home. In other words, had Jim remained an owner, Susan would have been able to exclude up to $500,000 in capital gains, and she would owe zero taxes.
Ensuring an equitable property settlement with respect to tax treatment. There are many ways this can go wrong, particularly for the spouse who is not financially savvy.
For example, when dividing stock in a taxable account, cost basis matters a lot. Cost basis is the amount you paid for a share of stock, mutual fund, or security.
Let’s imagine two spouses dividing shares of stock in a taxable account. Bob knows the ins and outs of the investments and proposes splitting it down the middle. Karen, who isn’t financially savvy, sees that they’re both receiving equal amounts and assumes that it’s fair. They both liquidate everything right after the divorce and move on. The next year, Bob pays nothing on his tax return, while Karen is surprised to find a huge tax bill. So what happened?
It turns out that Bob selected shares of stock that had a high basis, and shares that had gone down in value. The high basis stocks were selling for little more than what they cost, so they didn’t incur a big tax bill. And the shares that went down generated a capital loss, which meant Bob actually got to deduct the loss against his income.
On the other hand, Karen had low basis stock, which Bob had bought years ago. These shares grew over time, and there were capital gains in all of Karen’s holdings. When she sold everything, she became responsible for paying taxes on those gains.
This is just one example of how an ‘equitable’ settlement can turn out not-so-equitable, from a tax perspective.
Just remember: a property settlement could appear to be equitable, with everything split down to the last penny. And one spouse could end up in a much prettier position than the other. And don’t rely upon your lawyer, judge, or anyone else to point this out for you. You're going to have to be in charge of your own financial situation.
And if you’re ready to take the next step and work with a financial planner, you can learn more about how we work with clients right here.