No one enjoys the divorce process. It may be tempting to rush through the process, agreeing to whatever it takes to end the pain. While understandable this can lead to massive problems in the future. Even people that are attempting to use great caution in settling their divorce can make costly mistakes, especially if they attempt to do it on their own. Divorce lawyers exist for a reason. Their training and experience can save you time, money and heartache in the future. There are many possible traps waiting to be sprung on you in a divorce, but the most common “Seven Deadly Sins” are:
The First Deadly Sin: Not knowing the liquidity of assets.
Liquidity is the ability to convert an asset partially or fully into cash. This is an easy thing to determine with assets like savings accounts. All you need is a current statement to see the cash value. They are considered to be highly liquid, because a short trip to the nearest ATM results in one dollar in your hand for every dollar that is in the account. Other assets are not so easy. Assets like antiques, precious metals and collectables are difficult to sell quickly and the market is constantly changing. Depending on the market a house can be nearly impossible to sell, yet it obviously as value.
Most marital estates consist of more than just cash. That means that unless the parties agree to sell everything and split the proceeds someone is getting an asset as part of their share that the other side will not be getting. Often times one party will receive a non-liquid asset such as the house or a car and the other party will get a more liquid asset of “equal” value like cash or a brokerage account. This seems to make sense. If the house has $5,000 in equity in it and the other side gets $5,000 in cash it would seem fair. The problem with this solution is that while on the surface it appears to be equitable. However, the challenge is found in the party receiving the house’s cash flow. How will the person that keeps the house pay the bills if his or her major asset is not liquid? In other words the value in the house is trapped in the house. While you can borrow against the equity in the house it is difficult and selling a house is often not an option.
If the proposed settlement is one sided with regard to liquid assets it is a warning sign that one side or the other may be set up to fail when they can’t meet their living expenses, despite having assets.
The Second Deadly Sin: Failing to Consider the Impact of Taxes.
Most people don’t think about their taxes on a daily basis, but a misstep in negotiating your divorce could have a major impact on your taxes in the areas of capital gains, income tax, and alimony/support.
Capital gains are the increase in value of an asset from the amount it is currently worth minus what you paid for it. For example, if you purchased stock years ago for $10 per share of stock and it is now worth $20 per share, you have a capital gain of $10 per share. The increase in value is potentially taxable when you sell the asset. Stocks aren’t the only assets that can have capital gains taxes applied to them. Real estate (including your home), mutual fund accounts and most investments that have increased in value since their purchase could have capital gains taxes due on sale.
Where this becomes a problem is when your spouse offers to give you an asset that has a large capital gains tax associated with it in exchange for an asset that does not. They may appear to be equal in value but when you sell your asset you will have to pay the capital gains tax thereby reducing the overall amount you receive for your asset, or the value of the asset compared to when your spouse sells there asset and pays little or no capital gains tax. As an example, if your spouse says they want to keep a recently purchased rental property that you paid $100,000 in cash for and offers to give you a rental property that is currently worth $100,000 but was purchased years ago for $25,0000 they are not making you a fair offer. While these two assets may appear on paper to be of equal value if you were to sell both assets the newly purchased property that your spouse is keeping will not have a capital gain and the property you are being offered will have gain of $75,000 which will be taxed at around 15%, thereby reducing the value of the asset you received by roughly $11,000.
Income taxes can also be affected by a divorce settlement. The IRS considers alimony and spousal support to be income. This means that you have to report it and pay taxes on it at the end of the year. It also means that the person paying it gets to claim it as a deduction on their income tax return, unlike child support.
Even if spousal support is not a part of your settlement agreement you must consider how you will be filing your tax return for the last year that you are married. You have the option of filing jointly or separately. Filing jointly could result in an increased refund but ownership of that refund must be addressed. If you are filing separately you must consider who will be claiming the various tax exemptions that are available including the interest on your home loan and the children. The IRS has rules regarding the exemptions if you cannot agree but you can assign the deductions as part of your settlement.
The Third Deadly Sin: Not Understanding How Retirement Accounts Work.
One of the most fought over and argued about assets is the retirement account and for good reason. For many people the retirement account represents one of the largest assets of their marriage and is the basis for their life after work. For others it is an asset that can be used in the present to create a new, post marriage life. But in order to make good decisions about ownership of these accounts one must understand how they are divided and how they are cashed out.
If a retirement account is to be divided between the parties a Qualified Domestic Relations Order must be used. This is a complicated document that essentially splits the account into two accounts, one in each party’s name. It is important that a Qualified Domestic Relations Order be used to divide retirement accounts because without it the split would be considered and early distribution and would be subject to penalty taxes. If the plan is to place the funds you receive into a retirement account and leave them there then you might want to consult a financial adviser on getting the best return on your investment, but otherwise you don’t have much to worry about. On the other hand if the goal is to use the funds to live on or meet some expense such as a down payment on a new home then you will have to cash out your share of the retirement plan and face stiff penalties for doing so. It is important to keep these penalties in mind. If your share of the retirement is $100,000 you will only receive $80,000 if you cash it out.
Normally, distributions from a retirement plan prior to age 591/2 are considered “early distributions” and are subject to a 10% penalty tax as well as ordinary income tax. An exception to this rule, however, is a transfer to an ex-spouse as part of a divorce settlement. A Qualified Domestic Relations Order is used to affect this transfer. Income taxes still apply, so any assets you receive from a “qualified plan”, such as a 401(k), will be subject to a mandatory 20% tax withholding. For example, if you are awarded a $100,000 distribution from an ex-spouses 401(k) you will actually receive only $80,000.
The Fourth Deadly Sin: Not Considering Credit Ratings and Debt Issues.
Post-divorce you will be starting a new chapter in your life. Unfortunately the credit sins of your past may follow you. There are steps you can take to reduce the chances that a bad credit rating will follow you. First get a copy of your credit report. This will allow you to identify all accounts that have both your name and your soon to be ex-spouse’s. You will also be able to see any accounts that you were unaware of and any other potential credit problems that might be lurking.
The next step is to make sure that all joint accounts are closed and if possible paid off. If your name is on the account there is nothing a judge or order can do to change that and if your spouse decides not to pay the debt that they agreed to take on in the settlement agreement the creditor will be coming after you next.
The Fifth Deadly Sin: Failing to Consider Mortality and Insurance.
Many divorce decrees create financial obligations such as child support or spousal support. It is common for the decree to include language to the effect that the obligation to pay the amounts set forth in the decree continues past the death of the person ordered to pay as an obligation on their estate. This means that if your spouse agrees to pay support to you, but dies before their obligation is fulfilled their estate must continue to pay. The problem is that it is very common for people to leave their estates to their children so the obligation to pay is meaningless as the children get everything anyway. Or even worse, there is nothing in the estate to satisfy the obligation. That is where insurance comes in. It is vital that any obligation to make payments be tethered to an obligation to obtain and maintain a life insurance policy in an amount that will satisfy the payment obligation should your spouse pass away unexpectedly.
The Sixth Deadly Sin: Not Making a Budget.
A common mistake made in divorces is failing to create a realistic budget. Divorce is a major life change. Nothing, including your finances, will be the same afterwards. It is not uncommon for life styles to change based on the change from two incomes to one income or similar changes. It is vital that both parties prepare a realistic budget before accepting any settlement agreement. Agreeing to take on more debt than you can afford is a recipe for disaster. Before you can accept any settlement offer you must fully understand how much money you will be making in the future and how you will be spending it. What may be an attractive offer may not be feasible when you look at you budget and determine that you simply cannot afford it.
Additionally, understanding what your cost of living will be in the future will help you determine how much and what kind of assets you need out of the settlement. If you intend to maintain a certain life style you will need to know before negotiations begin what assets you will need to keep and what amount of support you must receive or can afford to pay to achieve your goals.
The Seventh Deadly Sin: Not Dividing Every Asset, Including the Hidden Ones.
In most divorces both parties are equally aware of the marital assets and debts or at least have equal access to this information, but this is not always the case. Many people take steps to restrict information or hide assets in an effort to retain more of the marital estate for themselves.
There are a number of ways that people try to hide assets and debts from their spouses, including secret accounts, hidden credit cards, cash dealings, and transferring money to others to hold. There are just as many ways to discovery these hidden assets including examining tax returns and other financial documents, pulling credit reports on yourself and your spouse, closely examining credit card bills and expenditures looking for gaps or unexplained spending, Obviously finding hidden assets can be difficult and time consuming. If you suspect your spouse is hiding assets you will need to work with an attorney and possibly an account that specializes in finding hidden assets before you can accept a settlement agreement.
Not all assets are left out of the settlement because they are hidden. Some are just missed. Pensions, insurance policies with cash value, and children’s college savings accounts are commonly over looked. Before you enter into a settlement agreement you should review your assets and debts with your attorney to make sure that nothing is missed.
The vast majority of divorces that are filed each year are resolved through agreement of the parties. These settlements range from fair and equitable for everyone to incredibly unfair and disastrous for one or both parties. Avoiding these seven deadly sins of divorce settlement can help you avoid disaster and move into the next chapter of your life with dignity and the ability to live your life the manner of your choosing.
Chris McHam is the lead attorney for McHam Law, a Round Rock, Texas based law firm focusing on family law, criminal defense, probate matters and civil litigation in Travis County, Williamson County, Hays County and Bell County
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