“How did we get to this point?” “What happened to us?” “When did it all go so terribly wrong?”
Couples facing the heartbreaking decision to stay married or to divorce often ask themselves these questions as they attempt to navigate the emotional, psychological, and physical hardships of the separation process. However, the financial implications of a divorce are often underestimated, and these can be ruinous to both parties if left unattended.
When working out a divorce settlement with your soon-to-be ex, it is important to remember that not all assets are created equal. Cash is different from real estate. Taxable accounts differ from retirement accounts. Each asset presents unique issues for you to consider.
Checking, Saving, & Money Market Accounts
Cash is indeed king. Cash offers liquidity and zero income tax consequences to the spouse who receives it. You can use it to establish an emergency reserve for a rainy day, or it can be invested in a globally diversified portfolio designed to help you meet intermediate to long-term investment goals. Divorcing parties should focus on having sufficient cash to get them through the tumult of the proceedings and to establish a firm economic footing for their life after divorce.
Taxable Brokerage Accounts
Individual, Joint, & Trust Accounts
Assets in an individual or joint brokerage account tend to be held for long-term goals and are more likely to include mutual funds, stocks, and bonds. They are liquid insomuch as they can be converted to cash quickly, but there are no assurances that they will be sold at a profit.
You run the risk of losing principal if investments are liquidated for less than their cost. The important thing to remember is that investments retain their character when transferred to an individual as part of a divorce settlement. Long-term assets remain long-term assets. Unrealized losses and gains are unchanged. This can be useful when trying to convert investments to cash.
Your financial advisor can “capture” tax losses to minimize income tax consequences while the overall portfolio is positioned to address goals that have a longer time horizon. Additionally, the mix of equities to bonds in the portfolio should be adjusted to reflect the revised goals and risk profile of the beneficiary spouse.
IRA, Roth IRA, & 401k
As the name implies, retirement assets are earmarked for retirement. Since retirement is presumably a long-term goal, the investments tend to be more aggressive, depending upon the demographics of the account holder. The positions in the account may have gone up considerably while the account holder saved for retirement, however, the lack of preferential tax rates when they are sold may mean losing some of those profits.
As funds are removed from retirement accounts they are generally 100% taxable at ordinary income tax rates. However, there are exceptions for nondeductible IRA and Roth IRA accounts. It is crucial to the spouse who retains control of retirement assets to know the income tax and possible penalties applied to distributions. Walking away from the negotiating table with a basket of retirement assets may be less favorable than cash or taxable accounts because of those possible taxes or penalties.
Primary, Secondary Homes, & Vacation Homes
Real estate may prove to be an excellent long-term investment, but it is not liquid and, consequently, can leave a party to a divorce feeling cash-strapped. When contemplating division of real property, you must consider the merits of the property as an investment, the ability to refinance and service the debt with one household income as opposed to two, and the availability of other, more liquid assets to fund living expenses and short-term financial needs.
The IRS allows up to $250,000 of the net realized gain on the qualified sale of a primary residence to be excluded from income. Under certain circumstances divorcing parties can actually agree to exclude up to $500,000 as joint owners. If the real estate is held as an investment, vacation home, or rental property, then it will usually retain its character in the hands of the inheriting spouse. Any passive loss carryovers or tax benefits that are tied to the property should be negotiated before a marital settlement agreement is signed.
Other Considerations: Business Ownership
If you or your spouse are business owners, it’s important to consider the value of the business in the divorce settlement. You may want to consider getting a calculation of value from a Certified Valuation Analyst to make sure the value is accurate.
Consider Working with a Professional
Remember that there is no substitute for professional counsel. If the rules of the game seem too daunting, please consider consulting with me or one of our other certified divorce financial analysts before making any final decisions.