Mishandling financial matters during a divorce can cost tens of thousands of dollars. Here is a list of the most common financial mistakes and pitfalls.
1. Setting unrealistic financial expectations Many people have an expectation that they will be able to maintain their lifestyle as it was prior to the divorce. Often however, this is simply not possible. Therefore it is necessary to fully understand the true costs of living and to carefully forecast how a proposed settlement will look in the future. To help with this we have a monthly spending budget spreadsheet which can be completed and helps to formulate a realistic post-divorce financial plan and budget.
2. Assuming that the custodial parent must always keep the house This is often a very emotional decision, especially when there are children living at home. However it can come as a greater shock to keep the house only to discover some time afterwards that you cannot afford to do so. This is another reason why it is so important to calculate the complete and accurate costs of living, before the divorce and financial settlement.
3. Not considering the basis differences between property and assets and the future tax implications of a proposed settlement The basis of an asset is what it cost you to obtain it. Whether it's your house, or a stock or mutual fund account, you need to know the basis. When it is sold there will be a tax event, either a capital gain or loss. All too often property is divided based on its current value without considering the tax basis. In order to make informed settlement decisions the tax basis of the assets must be considered.
4. Failure to look at the “big picture” Many times people falsely assume that a 50/50 division of marital property is an equitable settlement. However the only way to really understand what is fair is to prepare a detailed financial projection that clearly shows the effects of a proposed settlement. This will show all income and expenses for each spouse and individual cash flow and net worth forecasts to retirement age. It should also consider the effects of inflation, realistic growth estimates and taxes.
5. Being unaware of the rules concerning alimony and child support Alimony is tax deductible for the payer and taxable to the recipient. An IRS rule says that alimony cannot end or be reduced within 6 months before or after the date at which the child reaches age 18, the age of emancipation in Michigan. If this happens, the entire amount of alimony from the beginning is considered to be child support and trigger tax recapture. This can be a costly mistake that is easily avoided if you understand the rules.
6. Failing to guarantee alimony and/or child support Your ability to collect alimony and child support is only as good as your ex-spouse's ability to pay. If the unexpected happens, here are 3 common methods of insuring alimony and/or child support: 1) buy life insurance, 2) buy disability insurance, or 3) buy an annuity which will pay out the alimony or child support.
7. Assuming unsecured debt is divided after the divorce This area is often misunderstood by people and can be extremely costly. Basically credit cards and other unsecured debts incurred during the marriage are the responsibility of both spouses, no matter who incurred the debt. The credit card companies will not care if one spouse assumes the debt in a divorce, they will look to both parties in order to collect if they are not paid.
8. Not understanding the purpose of a Qualified Domestic Relations Order (QDRO) and when it should be drafted The Qualified Domestic Relations Order (QDRO) is a legal document that divides a qualified retirement account pursuant to a divorce. It instructs the plan administrator on the dollars or percentages to be divided and also deals with survivor benefits. Some plans do not allow for a QDRO, and the pension plan takes precedence over a court ruling. Therefore the plan documents must be reviewed first to see how the plan handles a division of retirement assets in the case of divorce. A QDRO should be prepared by an expert, and this should also be done before the divorce is final to be sure it will be accepted by the plan.
9. Not understanding the 72(t)(2)(c) section of the tax code - how to get money out of qualified retirement plans without paying the tax penalties This IRS rule says that any monies coming from a qualified plan to the non-employee spouse can be distributed to that spouse without incurring the 10% penalty if this person is less than 59 1/2 years old. However taxes will be paid on it, since it is income. If the monies are transferred from the qualified plan of the working spouse to an IRA (which is not a qualified plan) for the non- working spouse, and then a portion is withdrawn, the 10% penalty will then apply, in addition to income taxes.
10. Failing to effectively structure alimony payments Alimony is deductible for the payer. However if alimony is $15,000 per year or more and decreases by more than $10,000 per year during the first three years after the divorce, then it all may be subject to recapture and therefore becomes non-deductible and taxable. There are some exceptions but it is important to structure the payments properly from the start. There is also an opportunity under IRC71 of the tax code that allows certain payments (such as installment payments for property) to be treated as alimony for tax purposes (provided they meet certain conditions) and therefore be tax deductible.
