Dividing Assets in a Divorce-6 Mistakes To Avoid
Dividing assets is one of the most difficult things to do during the divorce process. Having to figure out who gets what can create additional stress. This additional stress simply makes this an even more complicated process.
And when you’re stressed, it’s easy to make mistakes in divorce cases. Here are six mistakes people often make in the during the property division process, and how you can take steps to avoid them.
Division of property mistake #1: Taking the short view
In the heat of the moment, it’s easy to say something like, “I’ll figure it out later.” The problem is, there are many ‘now’ decisions that can’t be reversed down the road. Or if you do try to make a different decision with a valuable asset, it’ll cost you a lot of money.
For example, let’s say you and your spouse divide his 401(k) plan.
You can have the judge issue a QDRO, or qualified domestic relations order. This QDRO tells the 401(k) plan administrator how the assets in the plan will be divided.
Usually, the divorcing spouse will roll the 401(k) assets into their own IRA, since transferring assets between retirement plans is not taxable. The IRS even allows early distributions from the 401(k) without penalty, pursuant to the QDRO.
While you still have to pay ordinary income tax on the distribution, spouses who are under 59 ½ are able to avoid the 10% early withdrawal penalty that the IRS levies on a distribution.
Let’s imagine that you’ve rolled everything into your IRA.
After the divorce, something unexpected pops up. You don’t have enough in your savings accounts to cover the cost.
If you NOW decide that you need to take some cash out of the IRA, you’ll have to pay the income tax. Plus the 10% early withdrawal penalty, if you’re under 59 ½.
Other common areas where taking the short view can cause long-term damage:
- Not thinking about your health insurance needs
- Keeping the family home
- Not paying attention to what your ex might be up to hiding, either on their financial affidavit or your tax return
To avoid these mistakes, it’s a good idea to build a roadmap for the rest of your life. Think about what life might look like a year from now, 5 years from now, or further down the road.
Continuously ask yourself these questions so you can start building your plan to get the right answers. And one of the top priorities is making sure you have cash.
Division of property mistake #2: Not making room for cash
One of the biggest mistakes a divorcing couple makes is underestimating how much cash they will need in their bank accounts after their divorce.
After all, an economic benefit of getting married is being able to pool together your resources. When you move in together, you no longer need to maintain two separate residences. You consolidate your expenses to support the marital residence.
You get to share grocery bills, utilities, furniture, etc. And likely, one of you takes the primary responsibility for paying the bills. The longer you are married, the more you get used to this.
When you get divorced, this works in reverse. When you get divorced, each of you has to maintain a separate residence, pay for separate utilities, furniture, etc.
Which means that each of you has to be prepared to pay your own bills. If you’re not prepared for it, or if you’re not the one used to paying the bills, you might be in for a shock.
Figuring out your life after divorce will take some time. And you need to have cash to support you for mortgage payments, paying down marital debt, or emergencies that come up.
On the other hand, if you don’t have enough cash, you might have to tap into other significant assets, stock options or a pension plan. These decisions might you even worse off.
This leads us to the next big mistake people make.
Division of property mistake #3: Keeping things you shouldn’t
Sometimes, it’s difficult to part with things you acquired in a marriage.
Perhaps it’s the marital home. Maybe it’s a car, or something else of sentimental value.
If you’re looking to keep something of significance, you should ask yourself how useful it will be to you after the divorce is finalized.
More importantly, you should ask yourself, “Is this thing more important than the cash I could currently get by selling it?” If the answer is “No,” then you should look toward giving it to your ex, or selling it.
Sometimes, it’s not this simple. Perhaps you’re both stuck with a house neither of you wants because the value of the house is less than the mortgage. This happened to a lot of people during the Great Recession.
Maybe you’re in the position of having to keep the furniture for your house because your ex wants nothing to do with it. At this point, you might be better off having a family law attorney help you understand the best way to move forward.
Division of property mistake #4: Not properly accounting for separate property
Nailing down the property division process is pretty difficult. It’s especially difficult if you’re having to deal with a spouse who is hiding assets or hiding income on their financial affidavit.
But even if you’ve identified the entire marital estate, not properly accounting for what’s considered joint property is a big mistake. Let’s briefly discuss the difference between marital property and non-marital property. Then we’ll discuss the mistakes that can occur when a divorcing couple mischaracterizes the property at stake.
The difference between marital property and separate property
Marital property is property that was acquired during the marriage, or property that was brought into the marriage and included by the spouse.
An example of marital property would be a rental property that was bought by the married couple. Even if the rental was placed in one spouse’s name, it still belongs to both spouses.
Nonmarital property would be property that you brought into the marriage, and kept separate. Or it could be money that you acquired from a separate source,
An example of non-marital property would be money that you inherited from a third party, like a grandparent. But once you put it into your joint bank accounts, it becomes marital property that was brought into the marriage.
Now that we have a clear understanding about the difference between marital and non-marital property, let’s look at what happens when one spouse takes advantage of the other.
One spouse allows the other spouse to not include something that should be considered marital property
This often happens when discussing what assets to include in the property division agreement. One spouse typically dismisses something like their former spouse’s IRA.
Usually, the assumption is that if it’s in the other spouse’s name, then it’s the other spouse’s separate property. This happens often with rental property and business interests.
It’s ALL marital property. Unless it needs to be specifically excluded from the list of divisible property.
One spouse includes property that should be considered separate property
On the flip side, what if your former spouse tries to convince you about that your separately held rental house should be part of the assets? Or the life insurance policy proceeds that you put into your separate savings account?
Ideally, you’d walk through these points during divorce mediation. And a mediator should help everyone understand what’s considered divisible property and what isn’t.
Division of property mistake #5: Accepting an improper value for marital property
Sometimes, it’s a matter of accuracy. Going through the property division agreement can be frustrating. But that doesn’t mean you should accept an improper value for the marital property you’re dividing.
Here are some ways that mistake can happen.
Treating appreciating assets and depreciating assets the same.
A house is an appreciating asset. Its fair market value will increase over time. Conversely, other things, like a car or household items are depreciating assets. Their monetary value goes down over time.
Sometimes, it feels easier to just ‘eyeball’ the value. Especially when you have a lot of assets to go through.
But usually, people over-estimate the value of their assets. And if you over-estimate the value of your depreciating assets, then you’ll be entitled to less of the appreciating assets. And over time, you’ll be worse off.
When you calculate the total value of the property, don’t let the other side push numbers in your face. If you don’t feel right, get an independent person to help you.
Because if you had to sell your $15,000 car, you probably wouldn’t get $15,000 for it. But your ex-spouse can sell $15,000 in stock options as soon as the market opens.
Division of property mistake #6: Not Considering Taxes
Taxes should be foremost on everyone’s mind when considering property division. There are two aspects to this:
- Minimizing unnecessary taxes.
- Ensuring an equitable property settlement with respect to tax treatment.
Minimizing unnecessary taxes
Many times, people make a decision that in hindsight, is very tax-inefficient. Had the desired result been known up front, that decision could have been made in a way that lowered or eliminated their tax bill.
For example, let’s say that Jim & Susan divorce. They’ve owned a house for 20 years. Susan wants to live in the house after their divorce until their 13-year old son graduates college.
However, they decide that Susan will keep the house, and Jim will receive his ‘share’ in the form of other investments and cash.
They draft the divorce settlement to reflect this, and Jim is no longer an owner of the house. Five years later, their son graduates high school and joins the Navy.
Susan wants to sell the house, but now there’s a problem. The house, which they bought 23 years ago for $100,000, is now worth $450,000. After minor renovation and real estate agent fees, Susan will still clear $400,000.
Because of the IRS’ capital gains tax rule, Susan can only exclude up to $250,000 of her $300,000 in capital gains. Had they remained married, they each would have had a $250,000 exclusion, for a total of $500,000.
However, Jim no longer meets the requirements, so Susan can only exclude $250,000. She will owe taxes on the last $50,000 profit, which she cannot exclude, which means she might owe as much as $10,000 in taxes.
Had they recognized this up front, they could have kept Jim as an owner. Section 121 also allows for a divorced spouse to use their ex-spouse’s tax exclusion as long as they both remain owners of the home.
In other words, had Jim remained an owner, Susan would have been able to exclude up to $500,000 in capital gains, and she would owe zero taxes. Then, they’d be able to sell the home after their son moves out and have no capital gains.
Make sure you account for the tax treatment of assets
Specifically, you want to make sure that your division of assets is equitable after taking taxes into account. And there are a couple of ways people trip up in this effort.
Pre-tax accounts vs. post-tax accounts
When is $1,000 not $1,000? Let’s imagine it another way. Which one would you rather have:
- $1,000 in cash from your joint accounts
- $1,000 in investments from your spouse’s pension plan
When going through your equitable division of assets, it’s easy for all the numbers to just start flowing together. And after a while, you forget that there are times when $1,000 isn’t $1,000.
Like when you would have to pay taxes when you pull the money from your retirement accounts. And maybe an early withdrawal penalty.
Don’t forget unrealized capital gains
If you’re dividing taxable investment accounts, a savvy spouse can trick an unsuspecting one. Let’s imagine you have two stock holdings, each worth $50,000.
- Stock A was purchased a year ago for about $60,000.
- Stock B was purchased 10 years ago for $10,000.
If you think they’re both the same, you’re mistaken. If you took Stock B, you’d have to pay capital gains taxes on $40,000 of investment growth. While your former spouse would actually be able to deduct $10,000 in losses on their tax return.
And even if you don’t sell now, you eventually will. And pay the taxes. So don’t let this happen to you.
If you’re not familiar with your investments, it is easy to make a mistake when trying to figure them out. When divvying up your assets, it’s important to know:
- What type of investment you’re dealing with.
- What type of accounts you’re trying to divide.
- Who has ownership of the accounts.
Ideally, you and your spouse split everything down the middle. But in a real world, that won’t happen. Just make sure that you’re paying attention, and asking questions about the tax impact of your property division.
Making mistakes with stock options and pension benefits are other common tax errors people can make in a divorce. If your divorce situation has either of these, you should consult with a Certified Divorce Financial Analyst (CDFA) to properly account for these assets in your property division.
Just remember: a property settlement could appear to be equitable, with everything split down to the last penny. And one spouse could end up in a much prettier position than the other.
Don’t rely upon your lawyer, judge, or anyone else to point this out for you. You’re going to have to be in charge of your own financial situation.