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Written by Gregory Palacorolla, CFP®

8 Common Financial Mistakes to Avoid During Divorce40-50% of married couples in the U.S. divorce, according to the American Psychological Association. There is a myriad of diverse issues, causes, and factors contributing to what seems to have become a common trend in society today. However, despite the diversity from relationship to relationship, there is a common thread that binds this population: the emotional, mental, and more often than not, the financial toll this life event inflicts. We took a deep dive into the financial component of divorce and came up with the top eight common financial mistakes to avoid during divorce.

Cashing in Investments to Pay Bills

Liquidating your investments to pay bills is not an ideal course of action. Not only could you potentially owe taxes upon the sale, but you may be hindering your ability to reach your long-term financial goals.

When you sell a stock, you are taxed on the profits you make. This is known as a capital gain. To calculate a capital gain, you simply subtract your purchase price (known as cost basis) from the price in which you sell (market value). If you have a capital gain, you will be required to pay taxes on that amount. If you own a stock for less than a year, it is known as a short-term capital gain and you are taxed based on the ordinary income tax rate (capital gains rate). Ultimately, the tax owed will be based on your income tax bracket. If your sale price is less than your purchase price, you will be generating a capital loss, in which a portion can be deducted from your income (up to $3,000). If you are indeed recognizing a capital gain, it may be wise to set aside a portion of the proceeds to cover the tax bill. Consulting with a financial advisor will help you understand the tax impact of these transactions as well as how this decision may affect your overall financial goals.

Not Understanding Tax Implications

Unfortunately, many don’t take the time to understand the tax implications associated with their actions. Divorce can be costly. Bills that used to be shared are now the sole responsibility of both individuals separately. Add in attorney fees, and unexpected costs and you have a potential situation for panic and rash decisions. Although a 401(k) is intended to be money you contribute and don’t touch until retirement, you’d be surprised by the number of people who tap into this retirement vehicle early. What many don’t realize is that if taxes aren’t withheld, you will get hit with a high tax bill, as well as a 10% penalty if you are under 59 ½.

Recent legislation has also created a potential tax hurdle for the divorced market segment. The Tax Cuts and Jobs Act of 2017 repealed the provisions that alimony is taxable to the recipient and deductible by the payer for any divorce executed after 2018. This causes higher taxes for the person ordered to make the alimony payments, which means there is less money to go around.

Many make the mistake of leaving important tax questions unanswered, such as who will be able to claim Head of Household status and determining which spouse will ultimately be the custodial parent for purposes of potential education and child care credits.

Keeping yourself abreast of recent changes in tax law, and taking the time to figure out how each decision is affected from a tax standpoint, will help you avoid costly mistakes. Working with a CPA and/or registered financial advisor can help sift through the sea of information in this area.

Ignoring Your Liability for Unsecured Debt

Did you know debt incurred during the marriage is a shared liability? When you settle your divorce, you’ll divide the responsibility for those debts. However, credit card companies can come after both parties regardless. Paying off all unsecured debts prior to the divorce being final is a good way to alleviate any issues in this department. Cancel any joint credit cards you may have opened during the marriage.

Discounting the Value of Retirement Plans

Understanding retirement plans, knowing the value they represent, how they work, and their role in your overall financial picture is crucial. You don’t want to leave money on the table simply because of a lack of knowledge. A Defined Benefit Pension Plan is funded and controlled by the employer. It pays monthly income at retirement. Even though the employee must wait until retirement to receive payments, the plan still has value today, and the ex-spouse is entitled to a share of that value. Hiring an actuary to calculate the present value of the DBP is an option.

Becoming familiar with a Qualified Domestic Relations Order (QDRO) is an advantageous exercise. This is a document that stipulates how the couple has decided to divide a defined contribution plan. It orders the plan administrator to pay the ex-spouse their court ordered share. Ask your company’s HR department to review the order prior to it being finalized. It is important to note, you will still have to pay tax on any of the money you withdraw from the plan. However, you can avoid the tax bill by rolling the money into an IRA directly.

A QDRO is a smart practice, but not required to split retirement accounts. If your agreement stipulates that you give part of your IRA to your ex-spouse, you can ask your custodian to transfer a percentage of a fixed dollar amount to your ex-spouse’s IRA. Don’t cash out and hand over proceeds or you’ll be paying taxes on the entire distribution.

Failure to Update Wills, Trusts, Retirement Plans, Bank Accounts & Life Insurance

This is an area that many people forget about. Many make the mistake of categorizing these documents into the “set and forget” column. Review of these documents should take place annually, and any time there has been a life event change. Typically, but not always, spouses are listed as beneficiaries on these documents. If you don’t remember to make the proper adjustments, your ex-spouse could end up receiving all of the financial proceeds and benefits in the event of your passing, rather than your present-day spouse or whoever else you would have wanted to inherit them. It is also important to ensure all Power of Attorney (POA) forms have been updated.

There are different types of POA forms. A Limited power of attorney gives someone else the power to act on your behalf for a very limited purpose and set amount of time. A General power of attorney is comprehensive and gives the person you designate all the power and rights that you have yourself. A Durable power of attorney can be general or limited, but it remains in effect after you become incapacitated and remains in effect until your death (unless you rescind it before you become incapacitated). You obviously want to ensure the person you want to be in this vital role is the same person documented in the paperwork.

Absence of a Housing Analysis

It is not unusual for couples to want to hold on to the family home somehow. Sometimes, if the house has a lower tax base, it may make sense for one of the individuals to keep it. However, there are certain factors that should not be ignored in making this decision. The house comes with more than just a mortgage. There are certain carrying costs associated with the home such as utility bills, property tax, insurance bills, and general maintenance.

An overall analysis of the costs should be done, and the effects of the new tax bill should be taken into effect. For example, the law caps the amount you can deduct in state and local taxes at $10,000/year. If you are married, you can exclude up to $500,000 in capital gains on the sale of your principal residence as long as you’ve occupied it for two of the past five years. For single homeowners, the exclusion is $250,000. So if you are considering downsizing, and the value of your home has significantly appreciated in value, you may want to think about the possibility of selling before the divorce is final.

Retail or Vacation Therapy

Divorce wreaks havoc on an individual in many ways. It isn’t unusual for newly divorced individuals to seek refuge from the emotional and mental strain through shopping to achieve a “fresh start makeover” or via a “moving on vacation.” While this may satisfy your present day wants, it can seriously handicap your long-term needs, and compromise your ability to reach your future goals. Taking the time to think through how a decision made today will impact you tomorrow and the many days that follow, will help to keep you grounded and a steward of financial responsibility.

Failure to Map Out a Revised Financial Plan

Mapping out a financial plan is obviously an excellent strategy for anyone, not just a recently divorced individual. It is extremely beneficial for those who have experienced a change in income, assets, liabilities, spending habits, and goals. Our lives are highly connected networks, with each component somehow linked to the next. If one area suffers damage, the likelihood of other areas being affected in some way, shape or form is fairly high. Looking at the big picture, not just each asset and source of income individually is paramount. Understanding how each impacts the other will help you make more financially sound decisions.

Write down your monthly and annual expenses. Devise a budget so you can visually see what is coming in and what is going out. Meet with a fiduciary such as a registered financial advisor to help you identify goals and develop smart financial strategies to achieve them.

Failing to understand all the financial pieces and how they have changed from your married life to your single life, can have a negative impact on your financial future. If you’d like to start the conversation, have any questions, or are ready to take the next step, please feel free to reach out to us at www.geierfinancial.com. You can also follow us on Facebook and LinkedIn.

 

Sources: Forbes/ The Balance/ Kiplinger

© Geier Asset Management, Inc. Feb. 2019. Gregory Palacorolla, CFP ® is Director of Wealth Management for Geier Asset Management, Inc., a Registered Investment Advisor. The articles & opinions expressed in this material were gathered from a variety of sources, but are reviewed by Geier Asset Management, Inc. prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of February 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual circumstances. In all cases, please contact your investment professional before making any investment choices. Geier Asset Management, Inc. is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.