It’s said that divorce is often the largest financial transaction a person will experience in their lifetime. The monetary impact can be enormous and, unfortunately, decisions need to be made at a time when emotions are running high and one’s judgment may not be at its best. No matter how overwhelmed you may feel, it’s important to think long-term and protect yourself and your finances. The following are some of the more common financial mistakes made in divorce – and how to avoid them.
Mistake #1: Not educating yourself
Unless you’ve been to law school or have intimate knowledge of the divorce process, you probably lack an understanding of the legal basics of divorce. I recently worked on a collaborative divorce case where both the husband and wife had difficulty wrapping their heads around the concept of community and separate property in California. “That credit card is her responsibility,” the husband stated emphatically. The team had to educate him that, under California law, any debt incurred during the marriage – no matter who swiped the card – is considered “community debt” and subject to a 50/50 division upon divorce.
By simply Googling “divorce laws” and the name of your state, you’ll find an enormous amount of information. Many attorneys break down the laws in easy-to-understand terms on their websites and sites like divorcemag.com contain useful articles written by divorce professionals. Doing some research before you even speak with an attorney will help you to ask the right questions and give you a better understanding of your situation once you actually walk into their office.
Mistake #2: Ignoring reality
Does the thought of your divorce make you want to pull the covers over your head and not get out of bed until it’s over? You’re not alone. Some days, just being able to put both feet on the floor in the morning is a major victory. But here’s the problem with avoiding reality for an extended period of time: Even in the midst of all of this emotional upheaval, you’re still going to need to make financial decisions which will have a long-term impact on your future. And the more clear-headed and realistic you are about your situation, the better those decisions will be.
Your first step should be to put together a realistic budget. Don’t estimate the numbers; instead, go back over credit card statements and bank accounts to determine what you actually spend. Use your budget as a springboard to determine where you can cut back on discretionary items, whether or not you can afford to stay in the marital home, and how you are going to begin planning for your financial future.
Mistake #3: Not understanding how retirement accounts are divided
Retirement savings and benefits are often one of the largest marital assets in a divorce and they can be very confusing. So let’s do a quick tutorial in order to provide some clarity.
- As you probably know, retirement accounts include 401(k) plans, IRAs, pension plans, deferred compensation plans, profit-sharing plans, and 403(b) plans.
- In a community property state such as California, retirement accounts earned during the marriage are considered to be community property and subject to a 50/50 division.
- Retirement accounts do not split automatically during divorce and must be divided by either the spouses or, if the spouses cannot agree, by the courts.
- IRAs, including traditional IRAs, Roth IRAs, and SEP-IRAs, are split in what’s known as a Transfer Incident to Divorce. However, 401(k)s and pension plans require a QDRO (Qualified Domestic Relations Order) to be divided. Preparing and submitting a QDRO is often a lengthy and detailed process. Keep in mind it may take up to 6 months to be completed.
Mistake #4: Forgetting about taxes
The tax implications of divorce can be enormous. While IRC §1041 states that any transfer of property between former spouses – if the transfer is incident to divorce – is tax free, that doesn’t mean there aren’t tax consequences in the future. Here are a few examples:
- The marital home – A married couple is typically able to exclude $500,000 of capital gains when they sell their primary residence. A single person may only exclude $250,000 of gain. Keep this in mind and think carefully about the tax consequences of keeping the house.
- Property transfers – A transfer of property from one spouse to another incident to a divorce is treated as a gift for income tax purposes. This means the value of the property is excluded from the recipient’s income. However, if the spouse who receives the property later sells it, any gain realized from the sale is subject to tax.
- Retirement plans – Retirement accounts can be a tax landmine. Transferring one spouse’s interest as a lump sum won’t trigger tax consequences. However, when a portion of the transfer is taken as cash or not directly rolled over into another retirement account, taxes – and possibly a tax penalty depending on the type of account – will apply.
Mistake #5: Not enlisting professional help
When you’re going through a divorce, it will seem as though everyone has a piece of advice to offer. A friend will tell you about an acquaintance’s cousin who was able to secure a settlement that included 75% of the marital assets and $100,000 a month in spousal support. And you’ll interview five different attorneys hoping one of them will promise you a similar outcome.
While emotional support is important, it’s best to rely on the advice of your team of professionals – rather than on the antidotal stories told by family and friends. An experienced attorney who focuses on family law, a CPA, and a financial advisor who is proficient in divorce should serve as your divorce “dream team” and help you navigate this difficult terrain. A therapist can also do wonders and offer insight your family and friends may not be able to provide. And it’s always a good idea to consult with an estate attorney to get the ball rolling on a new estate plan.
No matter how it may feel right now, the emotional upheaval of divorce will eventually end. You’ll embark on a new (and in most cases, better) life. And when you do, you’ll be glad you’ve made the right decisions for both yourself and your financial future.
This material is provided for general and educational purposes only, and is not legal, tax or investment advice. For each strategy or option mentioned, there are detailed tax rules that must be followed.