COMMON FINANCIAL MISTAKES IN DIVORCE
By Mary Lynne Dahl, CFP®
January 31, 2013
Mary Lynn Dahl
(SitNews) Ketchikan, Alaska - Divorce is costly! There are the emotional costs, the legal costs and the financial costs of splitting up the income, assets and debts. When most people marry, they never imagine that they might someday be in a meltdown of the marriage that will result in so much financial hardship. This article lists some of the most common financial mistakes that should be avoided during the divorce process. First question usually is, should you hire an attorney or do it yourself? The average divorce in the US is reported to cost about $15,000, with the average hourly attorney fee being $350, which is why some people don’t want to hire an attorney. Doing your own divorce may work if you and your spouse are reasonable, able to agree on child custody and support, willing to fully disclose all finances to the other party and willing to work with a mediator on the settlement, but you still might need a financial expert for professional valuation of specific assets, like real estate, pension plans and business interests, even when an attorney is not hired. If, however, you and your spouse are not able to communicate at all, are confrontational on all points and refuse to fully disclose all financial details, you will need to hire an attorney, each of you. The following is a list of common, deadly financial mistakes often made in a divorce.
- Mistake #1: Hiring one attorney for 2 spouses who are not 100% fully agreed on all issues. Your attorney is your lawyer, not your mediator.
- Mistake #2: Using your attorney as a financial planner. Attorneys are legal experts, not financial experts.
- Mistake #3: Hiring an extremely combative attorney in order to get “revenge” on your spouse. There are several reasons for this not being a good idea; one is that it tends to become very expensive and because divorce is no-fault in almost all states, most courts do not want to hear from you or your attorney that your spouse is a bad person who should be punished financially for his or her extramarital affairs or excess partying etc. etc. Don’t waste your money on this.
- Mistake #4: Assuming that a 50%/50% split of all assets is fair. Example: the house is worth $300,000 and the 401-(k) is worth $300,000. BUT…..one spouse recently borrowed $200,000 against the house (without telling the other spouse), resulting in it being worth only $100,000 as an asset. Do divorcing people really do this? YES, they do.
- Mistake #4: Failing to recognize the impact of taxes on the asset split being agreed to. Example: there are 2 stock accounts, each account worth $50,000. BUT…..one contains stocks purchased one year ago at an average cost of $40 per share, while the other contains stocks purchased 10 years ago at an average cost of $10 per share. When those shares are sold, the tax on the shares purchased for $10 per share will be 4 times the tax on the shares purchased for $40 per share. Bottom line: before splitting stocks or securities, the “basis” (purchase price + reinvested earnings) should be determined and the tax impact should be estimated.
- Mistake #5: Asking for the house when you can’t afford to keep it. One spouse with little or no income may want to stay in his or her home for sentimental reasons, but without the income needed to maintain the house, make the mortgage payments, pay the taxes and insurance, this may be unrealistic. Too often, one spouse wants to stay in the family home for emotional reasons, or “for the children”, but within a couple of years is forced to sell the home, and will be stuck with the costs of selling, the taxes due on gains (if applicable) and relocation expenses, usually in a residence of lesser value. In most cases, if the couple wants to continue to own the home, for whatever reason, it is better for them to own the home jointly, selling it jointly at a later date so that the split of the proceeds is truly equal and/or fair.
- Mistake #6: Lack of understanding of the retirement plans owned by the marriage. An often-misunderstood fact is that although the IRA is an “individual retirement account” and the 401(k) or pension plan is funded by the spouse through his or her employment, they are all property of the marriage, and when being split in a divorce, are subject to the marital rules. This means that neither spouse can assume that “my IRA is mine and your IRA is yours” and let it go at that. The values of all retirement accounts must be aggregated and split fairly, usually 50%/50%. It is possible to do this without triggering taxes, but this must be done correctly to avoid the taxes and penalties of early withdrawal.
- Mistake #7: Undervaluation of the defined benefit pension plans: A pension plan is a promise to pay a benefit at retirement and is generally based on the number of years of service to the employer times a formula. A common formula is about 2% of the average highest 3 years of salary. Example: 2% X $100,000 X 25 years of service = a pension benefit of $50,000. The problem is that in this kind of pension plan, there is no specific valuation of the plan at any one time. In some plans, the employee has made some of the contributions, usually less than 10% of the total contributions. The employer or pension plan administrator will keep track of the employee contributions, reporting them to the employee periodically. Thus, the spouse with a pension may show a statement that says he or she has contributed $100,000 to the plan and is promised a lifetime pension benefit of $50,000, and will state that the plan is worth the $100,000 that the employee has contributed….BUT this is incorrect. It is, in fact, worth about
- $1 million….otherwise, how could it pay the benefit of $50,000 per year, for a lifetime that will likely be 15-20 years, maybe more? Too often, because they are not financial experts, attorneys, courts and divorcing couples grossly underestimate the real value of a pension and agree to a totally unfair split. The correct way to split a pension is to do a Qualified Domestic Relations Order (QDRO) and indicate what percentage of the marital benefit will be paid to each spouse, at the time of the retirement of the employee spouse. Example: 28 years of marriage (the marital portion of the plan) and 35 years of service to the employer X 50% = 28/35 X 50%= 40% to the non-employee spouse and 60% to the employee spouse. Without the QDRO document, which requires specific legal language and which goes to the pension administrator, the pension will not be split, period. This is routinely misunderstood, often neglected by all parties and is a grave mistake. A financial expert should always be hired to make sure that this mistake does not happen.
- Mistake #9: Failure to insure the life of the spouse with continuing obligations, post-divorce. Example: one spouse is obligated to provide child support, or medical insurance for the children, or spousal support, or share in the expenses for investment real estate until the properties are sold, but dies unexpectedly in a car accident 1 year after the divorce. Without life insurance, the surviving spouse loses the assets or support awarded in the divorce, entirely. This can be avoided if the obligated spouse is insured, and the premiums are paid for by the other spouse, until the insurance is no longer needed.
- Mistake #10: Failure to recognize the tax filing changes that will occur as a result: You can no longer file jointly, both take the dependent exemptions , deductions and credits that you shared when married. These must be split between the parties, legally and practically. If one spouse gets the child care credit, the other cannot use it. If one gets the deduction for the mortgage interest, the other cannot deduct it, even if they continue to own the home jointly. If one parent claims the child or children as dependents, the other parent cannot claim them. An agreement must be written up at the time of divorce, stating who will get what tax write-offs, on what, and under what circumstances. Sometimes this agreement can shift the write-offs from year to year, or not, but it must be specific rather than assumed.
- Mistake #11: Agreeing to the house in exchange for the pension or retirement plan of the other spouse. Again, if the pension or retirement plans are not valued accurately, an unfair split of assets can easily occur. A pension valued at only the portion contributed by the employee spouse is grossly understated, and a house with a mortgage is likewise grossly overstated. Both assets must have actual equal or near-equal values if they are to be exchanged one for the other, in total. In addition, a house has ongoing costs associated with it, usually far more than a pension plan has. Example: a house has the expenses of homeowner’s insurance, property taxes, maintenance and periodic repairs. Whatever pension expenses there are generally are paid for by the employer who maintains the pension for the benefit of employees. Also, the house may or may not grow in value by some percentage; average annual real estate growth rates are about 3% nationally, but the pension is very likely to grow from additional contributions and investment gains, if well managed. The pension will ultimately be worth more than a house of equal value under normal circumstances. Unfortunately, at retirement, the house will not provide income unless it is sold, but the pension will provide lifetime income. They are not equal assets, even if they are initially valued correctly at the same amount.
In a sense, marriage is a business partnership that operates on the joint contributions of 2 people towards the good of the whole family. When that marriage is over, the splitting of the income, assets and debts is often the biggest business deal and most important financial decision either spouse will ever make. Being in a hurry to get it over with or walking away from a careful and fair settlement just because you are hurt or pressured is terribly unwise. It does not have to happen, so pay attention to this list so that you do not become a victim of this kind of unfair divorce settlement.
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©2013 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only.
Mary Lynne Dahl©2013
Mary Lynn Dahl can be reached
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