There are nearly one million divorces in the United States each year. Unfortunately, many divorcing spouses are financially devastated as a result. One reason is that too often, divorcing spouses accept unfair settlements, and find that a few years later they're experiencing serious financial challenges. Below, are seven of the most costly financial mistakes commonly made during a divorce.
Liquidity refers to your ability to convert an asset into cash. For example, a bank savings account is highly liquid, because you can simply withdraw funds from an ATM when you need them. An antique automobile, however, is illiquid because it's very difficult to sell this asset quickly and access the actual cash value.
Often, in a divorce settlement, one spouse will receive mostly illiquid assets, including the home, while the other party receives liquid assets such as retirement plans, brokerage accounts etc. The potential problem with this type of settlement has to do with cash flow. How will the spouse that keeps the home pay the bills if his or her major asset is illiquid? In worst-case scenarios, that spouse will have to sell the home, purchase something smaller and use the remaining equity or profits from the sale for living expenses.
If you will end up with very little liquid assets as a result of a proposed financial settlement, be sure that you will have enough cash flow throughout the years to handle your living expenses. If not, you may have to consider selling the home and other assets, or significantly decrease your expenses in order to meet your financial needs.
The effect of your settlement on various taxes can be very costly if not addressed thoroughly. Words like “capital gains, income tax, and alimony” may have a big impact on your tax payment. Capital gains are of particular importance and refer to the fair market value of an asset minus its cost. For example, if you paid $5 for a share of stock and it is now worth $25, you have a capital gain of $20. This applies to other assets such as real estate (including your home), mutual fund accounts and just about any investment that has appreciated in value. Be very careful that the property you're receiving in a settlement does not have large capital gains as compared with your spouse's property. Don't be fooled if your spouse offers you property of equal value but conveniently forgets to inform you of the tax liability. Be sure to consult a tax specialist before agreeing to any settlement proposal.
Retirement accounts raise tax-related issues, but their complexity merits a separate category. Normally, distributions from a retirement plan prior to age 59 1/2 are considered "early distributions" and are subject to a 10% penalty tax in addition to ordinary income tax. An exception to this rule, however, is a transfer of the retirement plan (or a portion of it) to a spouse as part of a divorce settlement. Depending on the type of retirement plan, you may need a Qualified Domestic Relations Order (QDRO) to complete this transfer. Income taxes still apply, so any assets you receive from a "qualified plan," such as a 401(k), will be subject to a mandatory 20% tax withholding. For example, if you are awarded a $100,000 distribution from your spouse's 401(k), you will actually receive only $80,000. To avoid this mandatory withholding, the transfer must be made directly to another retirement account, such as your own IRA. Once the assets are in your retirement account, you will once again be subject to the early distribution rules. If you need some of the assets to live on, or pay bills, make sure you take them out prior to transferring them to an IRA to avoid the 10% penalty. The division of a retirement account can be very complicated, especially if you need a QDRO. If so, you should contact an experienced attorney that can make sure you're taking all steps necessary to protect your rights.
There's nothing worse than starting out a new life with bad credit. You can take several steps during the divorce process to minimize the chances of this happening.
Most divorce judgments call for one of the parties to obtain a life insurance policy to insure the value of alimony payments, child support, or some other financial obligation. If you are the spouse for whom the insurance is obtained, it is critical that you are either the owner or irrevocable beneficiary of the policy. If not, your ex-spouse could easily stop making payments on the policy, and you would never know about it until the policy benefits are needed, but no longer exist. This could be devastating. As the owner or irrevocable beneficiary, you would be notified of any outstanding issues with the policy, such as non-payment of the premium, and could therefore take action and prevent the policy from lapsing or being cancelled.
One of the most common mistakes is the failure to budget based on your post-divorce income and lifestyle. This happens most often when one spouse keeps the home for the sake of the children or perhaps due to an emotional attachment. Because of the high value of the home, there are few other assets awarded in the settlement. The expense of maintaining the home and the lack of liquid assets often results in a rapid depletion of cash, eventually leaving no choice but to sell the home.
This scenario may be avoided if you take a good, hard look at your expenses versus liquid assets and income before you agree to any divorce settlement. A Certified Divorce Financial Analyst (CFDA) can help you project several years into the future and determine if you'll have enough resources to support your current lifestyle as well as your retirement years. This analysis should be completed prior to a settlement. If it is determined that you will be unable to maintain your lifestyle with the proposed offer, you have established a good case to request more assets, alimony, or child support.
Hopefully, you're not in a situation where you distrust your spouse and fear there are hidden assets that should be included in the settlement. Unfortunately, once a divorce is initiated, many spouses will do whatever they can to preserve what they feel is their "own" money. Some spouses maintain secret accounts or engage in other bad-faith financial activities throughout their entire marriage. If these assets are not uncovered, one spouse is certain to obtain an unfair settlement. Here are a few places to locate hidden assets:
This is not an exhaustive list of places to look. If you suspect that your spouse has hidden assets, you owe it to yourself to seek help from a financial professional. You should also contact an experienced family law attorney that can help you obtain essential information regarding hidden assets and ensure that your legal rights are fully protected.
For more information on uncovering hidden assets, see How to Find Hidden Assets in Divorce, by Lina Guillen.