Mistakes to Avoid
10 Critical Financial Mistakes in Divorce
- Not Producing an Accurate Budget
Clients often underestimate or omit expenses when they produce their initial budget. Later, during the divorce process or post-settlement, they feel they are unable to pay their bills. By using a divorce financial analyst, you can produce an accurate and complete budget that will carry you through the entire divorce process.
- Disregarding the Impact of Taxes on Assets in a Divorce Settlement
The bottom line to you from your settlement is the share of marital assets you get after the government (IRS) gets theirs. A 50/50 equitable distribution which seems fair from the outside may produce unexpected tax consequences that will diminish the after tax value to you. Before accepting a settlement, it is important to examine the value of the assets relative to your spouse on an after tax basis.
- Not Looking at After Tax Cash Flow when Analyzing the Settlement
Following are the lines on your tax return that change as a result of divorce:
- Your filing status changes from married joint to head of household (if you have at least one child living with you) or to single.
- The number of personal deductions will be reduced by at least one - your ex-spouse. However, it could be more if you agree to split deductions for dependents.
- Your income with your ex-spouse may put you in a lower bracket and you will be taxed at a different rate.
- Itemized deductions such as state income taxes, real estate taxes, mortgage interest, charitable contributions and non-reimbursed employee business expenses may affect your return differently.
- Alimony is taxable and you are required to pay quarterly estimated taxes on it.
- The effects of Alternate Minimum Tax may not be changed with your spouse's income and deductions
- Bringing an Emotional Attachment to Assets to the Divorce Negotiations
Assets such as the marital residence, your retirement, and assets purchased during the course of marriage can often bring emotionally charged discussion to the divorce negotiations. Many people can't afford the marital home post-divorce and give too low a priority to retirement planning. A house is an asset that provides a low return on investment yet it often requires major cash expenses, such as mortgage payments, taxes, and home repairs.
- Disregarding the Long Term Impact of Inflation
The effects of inflation on the cost of a child's college education 15 years in the future or retirement 20 years hence, can be dramatic. The rule of 72 is a simple way to judge the impact of inflation. If the inflation rate is 3%, the rule of 72 states that prices will double in 24 years (72/3=24). College costs at 5% inflation will double in 14.5 years (72/5=14.5).
- Forgetting to Update Estate Documents
After divorce, many people forget to change the beneficiaries on their IRA's, wills, life insurance policies, and qualified pension plans. If they die before these changes are made, their ex-spouse ends up inheriting their estate, which they really wanted to leave to their children, new partner/spouse, or charity.
- Failure to Adequately Insure the Divorce Settlement
Premature death or disability of your ex-spouse can result in loss of maintenance, child support, college tuition, or property settlement. Life and disability insurance can guarantee your payments and your family's security.
- Failure to Develop a Post-Divorce Financial Plan
One common fact in divorce that is often overlooked is that two households cost more to operate than one, but the income remains unchanged. Many people forget that their divorce settlement must last a significant amount of time, perhaps even the rest of their lives. Financial planning can help people transition from the married lifestyle to the single lifestyle by prioritizing financial goals, developing realistic expectations and producing written plans for allocation of financial resources.
- Not Using IRS Code Section 72t(2)c to get Distributions from Qualified Plans
During divorce, couples often face serious cash flow issues. Income stays the same, but expenses increase dramatically because there are two households to support. Changing or downsizing one or both party's lifestyle often requires a cash infusion to purchase, set up, or carry a second residence. Section 72t(2)c allows the alternate payee (the spouse who is not the employee) to take distributions from a qualified plan (not an IRA) without paying the 10% early distribution penalty even if they are younger than 59 1/2. The dsitribution is still subject to income tax. If the funds are first rolled over into an IRA then the preferred distribution rules no longer apply.
- Not Writing Off the Cost of Your Divorce
The portion of the cost of your divorce which relates to tax and financial advice is deductible on Schedule A of Form 1040. To substantiate this deduction, you should obtain a statement from your attorney or mediator delineating the cost of legal services and the amount attributable to tax and financial advice. Normally, the deductible portion of your divorce runs from 1/3 to 1/2 of the total cost. In order to deduct legal fees, you must be filing Schedule A (Itemized Deductions) and your deductible divorce fees must be greater than 2% of your income.
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