Written by Guest blogger: Leslie Thompson
During a divorce, a spouse who hasn’t been involved in the family’s finances can often be at a disadvantage during settlement negotiations. That’s why it’s so important for both spouses in the process of dissolving their marriage to understand their post-divorce financial needs and their current financial situation.
The following five items are often overlooked as part of the settlement process, but they’re vital areas to address:
- Cash flow needs
Understanding your need for immediate cash flow is extremely important in determining which assets would be the most beneficial for you to receive in the divorce. If immediate cash flow is a concern, the most valuable assets for you are ones you could sell easily and quickly (so-called liquid accounts), such as stocks, bonds, mutual funds and possibly Roth retirement accounts.
If immediate cash flow is not an issue, a combination of assets with various degrees of liquidity (taxable and retirement plan accounts) will likely be more beneficial long-term.
- Joint liabilities
Just because you agree to split a liability does not mean that the lender will honor your property-settlement agreement. Mortgages will need to be refinanced (if possible), any outstanding tax liabilities on jointly-filed returns will need to be paid and jointly-held credit cards will need to be canceled.
It is important that all liabilities are settled before completing a divorce, either by paying them off or by transferring them to the spouse taking responsibility for the debt.
It is also a good idea to run a credit report to determine if there are any outstanding debts that need to be addressed before settlement.
By securing proof that all liabilities have been settled before the divorce finalization, you’ll avoid an unpleasant surprise when a creditor demands payment from you for a liability that you thought had been settled.
- Taxes on assets
It’s critical to review the tax impact of your investments when evaluating the division of your assets. While two assets or investment accounts may have equal dollar values, their economic value could be vastly different when taxes are factored in.
For example, Roth IRA and Roth 401(k) accounts are funded with after-tax dollars; their future growth and distributions are tax-free. On the other hand, traditional 401(k)s and deductible IRAs are funded with pretax dollars and when you withdraw money from them, taxes will be due on both the amount you contributed and the growth of the investments. As such, Roths have a higher economic value than non-Roth 401(k) or deductible IRAs because they won’t be reduced by future taxes.
If you are younger than 59 and a half, you will pay income tax on withdrawals from non-Roth retirement accounts and possibly a 10% tax penalty. But you can avoid the 10% penalty if the distribution occurs within 12 months following a divorce.
You’ll also want to think about any unrealized capital gains on your taxable investments, since taxes will be due someday. Keep in mind that the first $250,000 of gain from the sale of a principal residence is sheltered from tax.
- Past tax returns
It’s a good idea to review the past three to five years of the tax returns you filed as a married couple. Aside from showing you how much income you two had in a given year, you’ll see whether there are any assets on the settlement agreement or if there are what are known as “tax assets” that need to be considered in the negotiation — such as capital loss carry-forwards, charitable contribution carry-forwards or net-operating losses.
“Tax assets” provide the user a reduction in future taxes and should be considered an asset when splitting the marital estate. But left unresolved, they can cause confusion or errors when filing future tax returns.
- Division of retirement assets
Retirement assets typically represent a large portion of a couple’s net worth and there are special rules to allow for the transfer to be tax-free. You’ll want to make sure the intricacies of these transfers are handled with care.
The divorce decree should specify that any IRA is to be treated as a “transfer incident to divorce” to avoid having the transfer classified as a taxable distribution. Be sure to determine if any basis exists from after-tax contributions made to the IRA — an amount that will be tax-free when distributed. (Consult a tax adviser on this.)
Employer-sponsored retirement plans transfer through a qualified domestic relations order, which requires specific information and approval by the court and plan administrator to allow for a tax-free qualified transfer.
Leslie Thompson is Managing Principal of Spectrum Management Group in Indianapolis. With over 20 years of financial industry experience, she has holds the Chartered Financial Analyst, Certified Divorce Financial Analyst and Certified Public Accountant designations.
*This blog is for information purposes only. Derek Parent and NFM, Inc. accept no liability for its content. Please consult a tax adviser or legal counsel for more information.*