Divorce Settlement Considerations

Following are brief summaries of these seven mistakes. Each of these areas can be quite complex, so we strongly recommend that you consult a professional prior to making a financial decision regarding a divorce settlement that may affect the rest of your life.

Liquidity refers to the ability to access the cash value of an asset. For example, a bank savings account is highly liquid, because you can simply withdraw funds from an ATM when you need them. An antique automobile, however, is nearly illiquid because it is very difficult to quickly sell this asset to access the actual cash value.

Often in a divorce settlement, one party will receive mostly illiquid assets, including the home, while the other party receives liquid assets such as retirement plans, brokerage accounts etc. On the surface, this scenario may appear to be equitable assuming that the home and other assets are of approximately the same value. However, the challenge lies in cash flow.

How will the party that keeps the home pay the bills if his or her major asset is illiquid? One can borrow against the equity of the home, but that's costly (closing costs, interest etc.) and it takes time to close the loan. In worst-case scenarios, the home must be sold, a smaller home is purchased and the remaining equity is utilized for living expenses.

If your proposed divorce settlement has very little liquidity, be sure that you will have enough cash flow throughout the years to handle your living expenses. If not, you may have to consider selling the home, other assets or significantly decrease your expenses in order to meet your budgetary needs.

The effect of your divorce settlement on various taxes can be very costly if not addressed thoroughly. Capital gains, income tax, and alimony are just a few of the areas that may be impacted.

Capital gains taxes need to be analyzed when property is being divided. Capital gains refer to the fair market value of an asset minus its cost. For example, if you paid $5 for a share of stock and it is now worth $25, you have a capital gain of $20. This applies to other assets such as real estate (including your home), mutual fund accounts and just about any investment that has appreciated in value. Be very careful that the property you are receiving in a settlement does not have large capital gains as compared with your ex-spouse's property. Don't be fooled if your spouse offers you property of equal value but conveniently forgets to inform you of the tax liability.

Income taxes are effected primarily by alimony payments and filing status. Alimony received is taxable as ordinary income, so a $50,000 payment received is actually worth $35,000 after taxes, assuming a 30% marginal state and federal tax bracket. On the other hand, the payer of alimony receives a tax deduction, so the same $50,000 payment actually costs the taxpayer $35,000 assuming the same tax bracket.

Filing status is an important decision after the divorce. If you were still married on 12/31 of the tax year, you have the option of filing a joint return. If you can peacefully deal with your spouse after the divorce, you should consider this option as it could save considerable tax for both parties. If you were divorced after 12/31 and you qualify, filing as head of household versus single can also save considerable tax dollars.

Retirement accounts are a tax related issue, but their complexity merits a separate category. If a large portion of your divorce settlement consists of retirement assets, you need to be aware of the many tax ramifications and potential penalties involved.

Normally, distributions from a retirement plan prior to age 59 1/2 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 (QDRO) 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.

To avoid this mandatory withholding, the transfer must be made directly to another retirement account, such as your own IRA. Once the assets are in your retirement account, you are now subject to the early distribution rules. If you need some of the assets to live on, or pay bills, make sure you take them out prior to transferring them to an IRA to avoid the 10% penalty.

It is important to note that IRA's are not qualified plans, so a QDRO is not needed to divide the assets. Also, there is no 20% mandatory tax withholding on a transfer. To avoid paying taxes, you must deposit any distribution from an IRA directly to your own IRA. If a check is sent to you, you must deposit the money into your own IRA within 60 days to avoid a taxable distribution.

Nothing is worse than starting out a new life with bad credit. Several steps can be taken during the divorce process to minimize the chances of this occurring.

First, obtain a copy of your credit report. This will identify all joint accounts, accounts you may not have been aware of, and any potential credit problems. Next, be sure to pay off and close all joint accounts prior to the divorce settlement and open new accounts in your own name. Unfortunately, creditors don't care how a separation agreement divides responsibility for joint debt (joint credit cards, auto loans etc.). Each person is liable for the full amount of debt until the balance is paid, hence the importance of dealing with this issue prior to your final divorce settlement.

Regarding income tax debt, even if the divorce is final, you may not be exempt from future tax liability. For three years after the divorce, the IRS can perform a random audit of a divorced couple's joint tax return. If it has good cause, the IRS can question a joint return for seven years. To avoid any potential problems down the road, your divorce settlement agreement should have provisions that spell out what happens if any additional penalties, interest or taxes are found as well as where the funds come from to pay for any expenses associated with an audit.

Most divorce decrees call for one of the parties to obtain a life insurance policy to insure the value of alimony payments, child support or some other financial need. If you are the person for whom the insurance is obtained, it is critical that you are either the owner or irrevocable beneficiary of the policy.

If you are not, the ex-spouse who took out the policy could easily stop making payments and you would never know about it until the policy is needed and it no longer exists. This could be financially devastating. As the owner or irrevocable beneficiary, you would be notified of any outstanding issues with the policy, such as non-payment of the premium, and could therefore take action and prevent the policy from lapsing or being canceled.

One of the most common mistakes made post-divorce is the failure to budget based on one's new lifestyle. We see this happen most often when one spouse keeps the home for the sake of the children or perhaps due to an emotional attachment. Because of the high value of the home, there are few other assets awarded in the settlement. The expense of maintaining the home and the lack of liquid assets often results in a rapid depletion of cash, leaving no choice but to sell the home. This scenario can be avoided if you take a good hard look at your expenses versus liquid assets and income.

Hopefully, you're not in a situation where you distrust your spouse and fear there are hidden assets that should be included in the settlement. Unfortunately, once a divorce is initiated, many individuals will do whatever they can to preserve what they feel is their own money. Some individuals maintain secret accounts or other financial activities throughout an entire marriage. If these assets are not exposed, one spouse is certain to obtain an unfair settlement.

There are multiple resources and methods used by financial professionals and attorneys to uncover potential hidden assets. Being aware of these may help you avoid being victimized by a dishonest spouse. Forensic accountants are generally the most commonly utilized professionals to assist in this area.

• Tax returns are one of the best places to start. Most people are uneasy about misleading the IRS for fear of penalties, fines and even prison. Go back at least 5 years to look for any inconsistencies in income, the presence of trusts, partnerships or real estate holdings.
• If your spouse is a business owner, corporate or partnership returns may show a change in salary, charging personal expenses to the company, or excessive retained earnings. Another common trick is to put a "friend" on the payroll, who agrees to give back the money paid to him after the divorce. A forensic tax professional is of tremendous help in this area.
• Checking account statements and canceled checks for the past few years can also be quite revealing. A canceled check for a purchase you never knew about, such as an investment property, can make a substantial difference in total assets to be divided.
• Savings accounts may reveal unusual deposits or withdrawals in amount or pattern that could point to a hidden asset such as a dividend producing investment. In addition, cash may be hidden almost anywhere.
• Brokerage statements are valuable in tracking the purchase and sale of securities. If securities are sold and the proceeds are not accounted for, you can be sure that the assets are out there somewhere.
• Expense accounts can be abused when corporations give employees a great deal of leeway in their expense account reporting. Cross checking between expense account disbursements and savings/checking account deposits may indicate a pattern of abuse if the deposits exceed legitimate business expenditures.
• Children's bank accounts may be opened as a custodial account for the intent of hiding assets as well. In some of these cases, interest is not reported as income on tax returns, and no return is filed for the children.

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