I recently gave a workshop for couples who are considering divorce and was asked “what are the biggest financial errors couples make when negotiating their divorces?” Afterwards, it occurred to me that it might be a good blog piece so that, hopefully, anyone reading this can avoid some of these financial pitfalls which are so easy to make when under the stress and strain of going through a divorce.
It’s important to note that what I’m addressing are mistakes I’ve seen couples make in good faith, not by being willfully deceiving. Unfortunately, there are an infinite number of stories of the ways divorcing couples have tried to take financial advantage of one another through the years, and those are stories for another time. Oftentimes though, folks just make mistakes, either from a lack of knowledge of the rules and regulations, or merely because they are overwhelmed by the weight of it all.
So, with that in mind, here the top 5 financial errors I see couples making when divorcing.
- Failing to consider tax status when dividing assets – Probably the most common mistake I encounter with divorcing couples is failing to consider the tax status of assets they are dividing up in their divorce. A simple example of this is a couple where one spouse has a savings account with $100,000 in it, and the other has a 401(K) with $100,000 in it. They decide that since each is worth the same amount, each will keep their own. Seems fair, right? Well the problem is that the taxability of each account is vastly different. The savings account is only taxed on any earnings or dividends accrued each year, and since it was funded with money that has already been taxed, the likelihood is that when funds are needed to be withdrawn, there will be no taxes due. The 401(K) on the other hand, has been funded with pre-tax dollars, so any amounts that need to be withdrawn in the future are fully taxable when taken out. In addition, should the funds be withdrawn from the 401(K) prior to reaching age 59 1/2, there is an additional 10% early withdrawal penalty that would likely apply. Even without the penalty, though, for someone paying 25% in federal taxes, and 5% state, the net value of that $100,000 401(K) is really only $70,000, when compared to the $100,000 savings account, simply due to the potential taxes due upon withdrawal.
- Failing to ascertain all workplace benefits – I recently had a couple going through a divorce and, after many weeks of negotiation, we were having trouble valuing an old workplace retirement account, from a job the wife had left many years before. I asked her to try to reach out to the old HR department to see if she could track them down, and see if they could send an old statement. In the course of trying to do that, they informed her that she had an old pension with a lifetime benefit, valued at over $150,000 in current dollars. There are many instances of workplace benefits like this, which may not have vested or do not necessarily produce statements each month, but still have significant value. It’s thus important, when gathering financial data, to reach out to the HR departments of any and all employers each spouse has spent a significant amount of time with.
- Failing to refinance a mortgage before the divorce is final – It is quite common for a divorcing couple to decide that one spouse will compensate the other in order keep the family home. Let’s say that Fred and Ginger have agreed that Fred will keep the family home post-divorce, giving Ginger other assets to make up for her share of the current equity. They can do quitclaims to change the titling of the home, but unless Fred refinances the original joint mortgage, Ginger is still financially responsible for the mortgage. If Fred stops making mortgage payments, it will affect Ginger’s credit report as though she had missed the payments herself. It’s also important to make sure that Fred will actually qualify on his own for the mortgage, otherwise, other arrangements will need to be made. The only way to ensure this doesn’t happen is for Fred to refinance that mortgage before the divorce is final.
- Failing to update estate-planning documents and beneficiary designations – A thorough review of all estate-planning documents and beneficiary designations is vitally important for anyone who has gone through a divorce. I had a financial planning client come to me last year who had been divorced for five years. As part of the planning process, we reviewed her beneficiary designations at her current custodian, and on her workplace retirement accounts. She was horrified to learn that her ex-husband was still the primary beneficiary on all of her accounts. The point: make sure to have all beneficiary designations updated and new estate planning documents prepared, especially in the case of a family trust in which the two spouses are co-trustees, once the divorce is final. Be sure not to make changes to your estate-planning documents or beneficiary designations without consulting your attorney first if your divorce isn’t final yet, as there are some specific rules about what can and what cannot be changed before it is.
- Failing to get insurance before divorce is final – Life insurance can be a valuable tool for divorcing couples to use to hedge against future financial hardship for the family, particularly when there is a major discrepancy in earning power between the two divorcing spouses. Often, the requirement to obtain life insurance is written into the settlement agreement, but the underwriting process is not completed before the divorce is final. This is a mistake, and can be a costly one. If coverage turns out not to be available due to health issues, or if the premiums are prohibitively expensive, other provisions, such as the creation of trusts or other estate-planning tools, will need to be be included in the settlement to protect against pre-mature death.
We all hope not to have to go through a divorce, but if we do, avoiding these mistakes should help to make the process a little less painful in the long run.