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June 16, 2009 |
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Cashing Out Of A Marriage |
Clients often don’t realize the financial impact of divorce, but advisors can help them recognize the implications.
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By Craig Skeels
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When a couple thinks of divorcing, their first thoughts often are about the unfortunate end to a once-happy relationship and the arduous road ahead of starting a new life.
Unfortunately, the process of divorce is much more complicated than many of your clients realize. Divorcing couples often must consider child custody, relocation, starting over and dividing belongings. But one of the most daunting tasks can be setting financials straight.
In fact, finances usually become the most overwhelming aspect of a divorce. Both parties involved either aren’t well versed in their financial situations, haven’t reassessed their new budget and cash flow, or don’t correctly evaluate retirement accounts. These factors can leave one or both parties feeling jilted, as well as unprepared for retirement.
To help divorcing clients avoid financial problems, an advisor can help them correctly value all investments, evaluate lifestyle changes and consider their options before agreeing to settlements on joint assets. If a client isn’t privy to all the needed financial information before negotiating a divorce, he or she could end up with an even bigger mess afterward.
Here are some typical financial complications that divorcing clients often don’t analyze enough but that you might guide them on:
Retirement Accounts: These tax-deferred nest eggs weren’t designed to be tapped prior to retirement. These often represent the largest portion of investment assets among U.S. households, but can be dramatically reduced by divorce. Often a person is entitled to as much as half of a former spouse’s 401k, IRA and/or pension plans. The settlements are worked out in the divorce agreement. Divorcing couples may also end up paying more in taxes on these accounts. Withdrawals before the designated retirement age (typically 59.5 or 55) are taxed at ordinary income tax rates and often are subject to federal and state penalties as well. This means that taxes and early withdrawal penalties (federal and state combined) could potentially reduce a withdrawal in some cases by 50% or more!
Often divorcing spouses don’t take into account that a retirement account asset such as an IRA or 401k doesn’t have the same present value as an after-tax investment, such as a savings account or mutual fund held outside a retirement plan, due to the deferred tax consequences. Fortunately, in a divorce a court can approve the transfer of a portion of one spouse’s retirement accounts into the other’s name and still keep the proceeds tax deferred. A financial advisor should seek qualified legal and tax advice to help a client set this up correctly.
Real Estate: Often one spouse (if not both) wants to keep the primary residence or other property assets, often for emotional reasons, even if he or she can’t afford to own them alone. While a home can help provide emotional and geographic stability, homes generally represent a large portion of a couple’s equity and are generally illiquid. If one spouse is awarded the home and the equity value that comes along with that, he or she is also on the hook for the mortgage payment—a potentially financially crippling burden.
A better solution is for each spouse to assess what he or she can afford under the new set of circumstances. If the current residence is not affordable, some options to consider are selling it and renting initially or purchasing a less expensive residence, renting the residence out for cash flow, and/or refinancing the debt to a lower fixed payment if it qualifies. As noted below, if the residence is sold, there could be different tax consequences depending on if it is sold before or after the divorce is finalized. Also if it is sold, the divorce agreement can specify how sales costs and taxes are shared.
Insurance: Health coverage may have only been provided through one spouse’s employer, so now the other spouse will need to buy his or her own. For a stay at home spouse or sole proprietor who relied on a spouse for coverage, this could mean a dramatic increase in annual expenses if they now have to buy insurance on their own. This potential expense can be quantified with some price shopping ahead of time, and then taken into account in the divorce agreement.
In addition, life insurance needs could change as there may no longer be a dependent spouse but a desire to provide for dependents until they’re age 18. As with the health insurance, one spouse may have had group coverage which will now no longer cover the other spouse. It may make sense also for one spouse who is receiving an ongoing form of support, such as alimony or child support, to maintain life and disability coverage on the other to help insure it will be received. Divorcing couples often don’t consider that they need to change preferred beneficiaries and update estate plans, including wills, powers of attorney, trusts, etc. A financial advisor helping a client with such issues should get an estate attorney’s help.
Income Taxes: Going from married to single changes exemptions and personal deductions on the future tax returns. All things being equal (which they rarely are!), the total amount of income tax owed on the same income could increase.
Also, certain limitations will change. For example, a married couple filing a joint income tax return and who sold their primary residence during that tax year usually can exclude up to $500,000 of their qualifying profit from capital gains tax. A single taxpayer, on the other hand, can only exclude up to $250,000. As a result, whether a primary residence is sold before or after a divorce could significantly impact taxes. A financial advisor should evaluate other possible tax issues and traps with an expert as well.
Future Cash Flow: Future income and expenses for both newly divorced individuals will undergo changes. A financial advisor needs to help a client evaluate these issues and come up with sensible solutions. A financial plan should help delineate what a divorcing client’s new short- and long-term financial goals are, look at current cash flow, provide a net-worth summary, evaluate financial risks, make sure needed insurance is in place and offer a plan of action to help meet the targeted goals.
Craig Skeels, CFP, CLU and ChFC, is managing director at Apex Wealth Management Group, a division of United Capital Financial Advisers, Inc., in Oxnard, Calif. For nearly three decades, Skeels has been advising retirees to continuously monitor and reevaluate their decisions regarding financial, tax, health and estate issues. For more information, please visit www.apex500.com.
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