Heather L. Locus
July 19, 2023
We learn at an early age that we all make mistakes, and no one is perfect. And while that does ring true, there are certain instances in life where minimizing mistakes is particularly important. One of those instances is divorce. Having helped many individuals through the divorce process, the missteps people make throughout the process often come back to haunt them post-settlement. That begs the question, what are some common mistakes people make during the divorce process – and how do the smart and savvy avoid them?
Separating finances is a large part of the divorce process. To break it down, we will explore common blunders in five areas: lifestyle, taxes, the family home, legalities, and insurance.
Many people who have gone through a divorce cannot afford to maintain the same lifestyle they grew accustomed to as a couple. Regardless of how much or little household income there is, few couples live on half, let alone now in two separate homes, with an investment portfolio that has been split. The wise realize this early in the process and are realistic about the lifestyle they can afford in their next chapter.
It is important to have an accurate picture of your expenses. It may seem easy at first to scale back and bring costs down, but if you are not accustomed to living on a budget, it will take some time to build that muscle. You will need to get your bearings and learn what you truly need to live on and, as a result, what you can cut out.
If you have children, it is also smart to discuss with them how the finances may change going forward. Of course, this conversation varies based on the age of your kids. Discuss with your kids that the things they have grown accustomed to may no longer be affordable. You will likely find that uncertainty or overindulgence is more dangerous to children than their new financial reality.
Taxes are very complex, and to best avoid mistakes in this category, it is likely necessary to enlist the help of professionals. A great attorney, financial planner, and accountant round out a team that can likely help you dodge any of the following common pitfalls.
Throughout your property settlement negotiation, bear in mind that not all same-valued assets are worth the same. This is because assets like retirement accounts (for example, employer-sponsored 401(k)s or individual retirement accounts) are taxed differently than after-tax brokerage accounts.
With a tax-deferred retirement account like a traditional 401(k), any dollars contributed grow tax-free until withdrawn, at which point they are taxed like employment income (10%, 12%, 22%, 24%, 32%, 35%, or 37% marginal brackets based on taxable income). In contrast, any dollars contributed to a brokerage account are contributed on an after-tax basis and are subject to preferential capital gains (0%, 15%, or 20% based on adjusted gross income) tax upon withdrawal.
Another distinction of after-tax accounts is that capital gains tax is only levied on any capital gain in existence at the time of sale (also referred to as “realized”). This means if the assets decrease in value from when they were purchased (known as cost basis), there is no tax due. There could potentially be tax savings if a capital loss is realized. Those going through divorce should calculate the taxable gain or loss of all securities included in their investment portfolio. For example, a security worth $100,000 with a $90,000 cost basis is worth substantially more after-tax than a security worth $100,000 with a $50,000 cost basis.
As previously mentioned, if a security is sold at a loss in an after-tax account, a capital loss is realized. To the extent there are no capital gains to offset capital losses, the IRS allows a $3,000 deduction from ordinary income and for any additional losses to be carried forward into future tax years. When going through a divorce, you should always confirm if any capital loss carryforwards apply – and, more importantly, specify how those losses will be split between you and your ex in your agreement.
The Family Home
Regarding the family home, a common mistake is keeping a home that is not affordable because there are emotional ties or a fear that relocating will have an adverse effect on the kids. Houses can be acceptable low-returning financial assets if you can afford the mortgage, taxes, and upkeep, which are typically higher than people estimate. It is unlikely your home will appreciate as much as an investment portfolio, and is also much less liquid, so weigh the trade-off and opportunity cost carefully.
Another common misstep when considering the family home is agreeing to refinance immediately. Your creditworthiness will now be based on your financial strength alone. If you earn an income, you will likely need to receive six months of spousal support and/or child support before using that as an income stream to qualify for a mortgage. You will also likely need to show you will be receiving the same amount for at least three years past your closing date.
Besides the timeline issues, mortgage rates may be higher now than when your mortgage originated. While it won’t work in every case (especially in high-conflict divorces), keeping the mortgage as-is may provide smart cost savings and could be worth negotiating into your settlement.
If you or your ex have an employer-sponsored retirement plan that is split pursuant to the divorce, not many people realize there is a separate legal process after the divorce is finalized to divide these accounts. A Qualified Domestic Relations Order (QDRO) grants you the right to part of the retirement benefits your spouse may have earned in an employer-sponsored retirement plan. It is critical that your QDRO be executed properly and that it is written according to the specific company’s plan requirements and implemented as soon as possible. Surprisingly, some people wait until retirement to find out the QDRO was not executed properly, so their ex-spouse keeps the benefits.
Another legal process that usually has people cringing is their estate plan. Not changing beneficiaries and estate planning documents post-divorce is a huge mistake. Post-divorce, your entire estate will be different, and it is wise to consult an estate planning attorney to make sure you understand the legal plans outlining how your assets pass if something happens to you before the divorce is final. Many people change their healthcare and financial Powers of Attorney during the divorce process. However, it is a good idea to check with your divorce attorney before altering your Will, trust, or beneficiary designations to see what impact it may have on your divorce negotiations. Once your divorce is finalized, most beneficiary designations remain in place and must be changed from your ex. Otherwise, your former spouse could still receive benefits upon your death, even if that is not aligned with your intent.
Finally, divorcing individuals miss understanding whether spousal support and child support are properly insured upon death or disability of the payor. It is ideal but rare for the recipient to own disability and life insurance policies on the payor, though it may not be required by law and is complicated and costly. The recipient should confirm that any insurance policy agreed to be kept in place is still in force annually and that they are the named beneficiary. Be aware that even if your former spouse is supposed to maintain insurance if the policy lapses the insurance company will not pay out benefits to you.
Many divorcing men and women are not experienced with the process, so mistakes are easy to make. Create a strong team to guide you around these common pitfalls. There will still be instances where things do not go totally to plan but minimizing the big blunders will set you on the smoothest path possible.
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