How to Navigate Some of the Financial Impacts of Divorce
Divorce has implications that spread far beyond the emotional ones. Amid a divorce, it can be too easy to make emotional decisions that will impact your financial picture for years to come. To that end, this article discusses some of the financial implications of divorce and discuss some pitfalls to avoid.
Lawyering Up Versus Mediating
When thinking about divorce, it’s easy to picture the television version. What comes to mind is conflict, name-calling, private investigators, and telling your lawyer to take them for every cent they’re worth. Lawyering up ensures that your interests are prioritized, but it can be very costly.
Not all divorce is contentious. When many divorcing couples tell me they are splitting up, they aim to do it amicably. If you want to work together to come to an agreement, hiring a mediator is an alternative that may save time and money. It’s important to think about your personal situation to determine which approach is the right one for you.
Housing
When a married couple purchases a home together, it is often at the top of their joint budget. The newly married couple wanted to build a beautiful life together and the beautiful home with the extra bedrooms in the ideal neighborhood with the good school district was part of that plan. Upon divorce, I’ve found that oftentimes, one of the spouses wants to keep the primary home and buy the other out of their interest. This works if the spouse who wants to keep the home can qualify for a mortgage on their own and has sufficient assets to pay the exiting spouse out.
Unfortunately, this is often not the case. The emotional aspect can win out and both the staying and exiting spouse can experience a negative hit to their finances. In the process of trying to hold on to their housing dreams, it’s common for the couple to sacrifice most of their paycheck and their retirement, education, and vacation funds.
If the primary home has significant appreciation, it may make sense to consider selling out completely while still married and take advantage of $500,000 in capital gains exclusion, meaning that the first $500,000 in gains would not be subject to taxes if you’ve lived in the home and it was your primary residence for three out of the last five years. In any case, you should consult directly with your own qualified tax, accounting, and legal advisors before taking any action at all.
Debt and Taxes
You and a soon-to-be-ex-spouse may have debts together. These debts can include credit cards, mortgages, school loans, car loans, etc. Usually, debts will be lumped together with asset distributions, such as choosing to take the car and taking on the car loan. When it comes to larger debts, the person looking to take on the debt must be wary, making sure that they can qualify for the loan from an asset, income, and credit level.
Of course, in a higher interest rate environment, the payment on the new loan will likely be higher interest than the old joint loan made during a time of lower interest rates. It may be possible to refinance a loan at a lower rate sometime in the future, but it’s generally not advisable to take on a loan with a payment that is more than you can comfortably afford hoping that you’ll be able to refinance later.
If you file your taxes married filing jointly, you will still need to complete a final tax return together the year of the divorce. Working with a tax professional can help couples sort out this aspect of divorce, and that comes with another expense to add to the financial costs of divorce.
Retirement Versus Non-Retirement Assets
Retirement assets are rarely left unscathed when it comes to divorce. I often see people dipping into retirement assets before the age of 59 ½ to create some liquidity for things like buying the other spouse out of the home. Retirement assets can transfer without taxes or penalties to an ex-spouse if they are maintained as retirement assets but as soon as a premature distribution occurs, there are a whole slew of issues.
For pre-tax accounts, you are paying state and federal income taxes on the full amount distributed plus a 10% IRS penalty. For example, if you lived in California, had $100,000 in earned income, and distributed $400,000 in retirement assets, your effective tax rate would be 41.71% in addition to the 10% IRS penalty. So, you would be losing half the value of your assets to taxes and penalties and losing the benefits of compounding interest towards your future retirement.
Non-retirement assets are the most flexible when it comes to distributing assets for a divorce. The most common are bank accounts and investment accounts. If assets that need to be sold are subject to significant capital gains, it may make sense to consider selling while still married, since you may have a more favorable tax bracket at the time.
You might consider treating premature distribution of retirement assets as a last resort, not as an easy solution to a current liquidity problem. Non-retirement assets should be primarily considered for needed liquidity.
This article was written by Cicely Jones from Forbes and was legally licensed through the Industry Dive Content Marketplace. Please direct all licensing questions to legal@industrydive.com.
