The start of a new year brings opportunities to start fresh … sometimes this means filing for divorce. If this is the case in your situation, there are some important issues that you should be aware of when it comes to your finances.
How do I get my finances ready?
The most important thing to do is to start collecting statements from your accounts: bank, credit card, mortgage, utilities, retirement accounts, brokerage accounts, life insurance, car loans/leases etc. This way, when you meet with your attorney or CDFA (certified divorce financial analyst) you will be ahead of the game when it comes to speaking about your current financial situation. Also, since December 31st, the end of the year, was just a few weeks ago, most companies will be creating annual statements. Some companies don’t necessarily send monthly or quarterly statements but they must send an annual one. If it isn’t in print format, it will be available on line. So, what if you’re not the person who handles the finances? This could be a bit trickier, however, here is where working with a CDFA can be helpful. A CDFA can work with the attorney/mediator to request these statements from your spouse and compile the information into a usable, easy to understand format.
Should I be more conservative during with spending during the divorce process?
In any time of extreme change in a person’s life it is wise to be more conservative when it comes to discretionary spending. This refers to things that are more “wants” than “needs”. It is going to be a big adjustment for the family as they separate households and finances. Individual budgets need to be created. For many people who have never actually done a budget, this can be a daunting task. A CDFA can help someone put a budget together that makes sense so they can see where there money is really going. This is not the time to be making big purchases that don’t come under the category of food, clothing, shelter … and by “food” I’m not talking about eating out every night of the week; and by “clothing” I’m suggesting that you look twice at those designer labels and realize that this might be more of a luxury item right now and may not fit into your budget. I give this same advice to high net worth individuals … I caution them to hold back until they see where the dust settles and they have a more realistic picture of what their new normal looks like.
How can I avoid potential financial disaster? What are the things I need to look out for?
The first answer to this question is a category unto itself and that is your individual credit score! The key here, and the first step, is to get your CREDIT REPORT PRINTED! The biggest problem with separating marital finances is that people forget that it’s not just about the assets … it’s also about the DEBT, and even though your individual name may not be on that credit card, that car loan … debt accumulated during the marriage is a marital obligation. Pulling your credit report is not just about knowing your score. While this is important, it’s more about seeing what “obligations” are in your name. There may be a joint account that you’re not even aware of. You should also get a copy of your spouse’s credit report for the same exact reason.
The second answer is to make sure you understand the immediate AND long-term ramifications of what you decide to “split” and what you decide to “keep” of the marital assets. So many people try to trade apples for oranges and they don’t consider things like capital gains tax on a house or stock portfolio or the tax impact of future distributions from a retirement account. They think that just because the bottom line numbers may be equal that this is actually “equitable distribution”. IT’S NOT!
For example, a martial residence with an “equity value” of $750,000 is NOT the same as a 401(k) worth $750,000. Why? Because if the house is sold when the couple is still married, they have a combined $500,000 of capital gains tax exemption on the sale. An individual only has $250,000. So if the sale value of the house is $1,100,000 and the mortgage is $250,000, the net proceeds of the house (not taking sales commissions and other fees into account right now) would be $850,000. You would also need to know the cost basis of the house which is the purchase price plus capital improvements. So, let’s say they purchased the house for $500,000 and made $50,000 of improvements. That brings their cost basis to $550,000. Net sale of $850,000 – $550,000 = gain of $300,000, which as a married couple is covered by their joint exemption. BUT as an individual, the exemption is only $250,000. If one person “received” the house in the equitable distribution, they would owe tax on $50,000 upon sale.
Likewise, the 401(k) being $750,000 must be tax impacted for future distributions. Every penny of the money that is in a 401(k) or other retirement account is taxed upon distribution of at least 10%. Depending on the individual’s tax bracket at the time of the future distribution there could be the tax could be 25 – 30%. That said, the 401(k) would have to be worth $825,000 in order for it to “equal” the equity value of the house.
Not knowing these things could absolutely put an individual in a position of being blown up on a financial land mine. Working with a CDFA will mitigate the risk of doing just that.