Written by: Nicole Gobel, CPA, CDFA®
I know from personal experience that going through divorce can be painful emotionally, mentally, and financially. Whether you are the one that has initiated the separation or not, it is unlikely that both spouses will be able to maintain the same standard of living after dividing assets and incomes. While there are non-financial decisions that may take priority such as custody of children or pets, there are some key items to focus on when considering the financial side of divorce.
In this article we will discuss three top priorities to consider:
- Cash Flow
- Income Taxes
It may seem obvious, but the nature of assets is sometimes ignored when considering what each spouse should retain after a divorce. The parent who has custody of the children, may ideally want to keep the family home, and allow them to remain in the same school and community with the intention of providing some stability during a difficult transition. However, since the family home often makes up a large portion of a couple’s total wealth, he or she may end up with an illiquid asset that can be a drain on any other assets received. Without significant child and spousal support, it may not be possible to continue paying the mortgage, real estate taxes and upkeep on the current residence.
Some couples choose to retain the current residence jointly for a specified period of time, for example until the youngest child leaves for college. There can be advantages to doing so if both parties agree as this allows the exclusion of up to $500,000 in gain jointly upon sale vs. only a $250,000 gain exclusion on a primary residence for a single individual and only one individual needs to remain in the home to qualify. In today’s higher interest rate environment if a non-working or lower earning spouse is hoping to retain a residence with an existing mortgage it will be difficult to qualify and most likely more expensive to refinance at current rates. This of course requires that there are enough liquid assets and income to support both the family home and another living situation for the other spouse. In some cases, it truly is better for everyone to sell the home immediately and split the proceeds.
Although I’ve used the example of the family home, there are many other assets that can be subject to liquidity issues such as ownership in a business, other real estate, expensive vehicles, artwork, or collectibles. While these items might hold both monetary and emotional value for you it’s important not to be left with too many illiquid assets that you may later be forced to sell to support cash flow needs.
Whether working through a divorce collaboratively, through mediation, or in court, both parties will need to provide documentation on assets, liabilities, income, and expenses. While one spouse may be focused on the total amount of assets retained, it would be a mistake to ignore how much cash flow is required for the expected post-divorce lifestyle. It is important to work up a realistic budget of what is truly needed to support the new living situation and basic needs.
As noted earlier, retaining the family home might make sense in the short term but it is important to understand the cash outlay required to keep and maintain the home. If there is a downturn in the real estate market or major improvements that need to be made prior to sale, this could prove to be a difficult situation. If rental real estate is retained it may provide rental income, however, there are still ongoing expenses and the risk of being without a tenant or the need for repairs. In both situations it is important to understand the cash flow needed to retain these assets before agreeing to keep them.
Retaining cash and brokerage accounts can be a great way to have assets that are liquid but that may also be generating cash flow through interest and dividends. Access to an annuity or employer pension providing a fixed income can also be a great way to guarantee at least a minimum amount of expenses are met. An award of some portion of a future pension would be calculated based on the present value with agreed upon interest and return assumptions. Retirement accounts can also provide for future or current cash flow depending on your age, but it is important to understand how distributions will be taxed.
Social Security benefits are another consideration. If married for at least 10 years, a divorced spouse is entitled to half of the ex-spouse’s Social Security retirement benefits as long as they do not remarry, are over age 62 and their own benefit is not higher. This can have a big impact if one spouse was not working for most of the marriage or divorce occurs later in life.
If spousal support is awarded it is also important that the payor obtain life insurance for at least the term of the support. This ensures that if the payor dies prematurely the intended support can still be met with the life insurance proceeds.
As a CPA, I naturally consider the tax impact of any financial or investment decision my client is considering. Income taxes can have a major effect on the net amount each spouse receives in the initial settlement as well as long term.
As noted earlier, retaining a family home jointly prior to sale allows for a much larger gain exclusion. Rental real estate also comes with tax implications. The spouse that retains the asset inherits the original cost basis and is also considered to have benefited from depreciating the property since owned. Therefore, upon later sale the owner will not only have to recognize and pay tax on the capital gain above the original cost basis plus improvements but must pay tax on the recapture of depreciation which can be significant. It’s important to have a CPA review the tax records for the property before deciding.
There are also capital gain considerations for brokerage accounts. Ensure that you have a full understanding of the built-in capital gains and do not agree to accept the low-cost basis positions leaving you with a smaller net amount if you choose to liquidate for cash. Also keep in mind that securities that have been held for over a year receive more favorable long-term capital gain treatment, typically 15% for Federal purposes, vs. short-term holdings that are taxed at your marginal tax rate.
Taxability of retirement accounts is also key as well as your age at divorce. Tax-deferred retirement accounts including traditional IRAs as well as any pre-tax funds in employer retirement plans will be taxed upon distribution and are typically subject to penalties if accessed prior to 59 ½ unless you have separated from your employer. IRAs can be split through a divorce agreement; however, any qualified plans will require a Qualified Domestic Relationship Order (QDRO) that should be finalized prior to the divorce. When utilizing a QDRO there is a one-time opportunity to take a distribution as part of the divorce settlement and not pay the 10% early withdrawal penalty if these funds are required but they are still subject to income tax.
Roth IRAs are certainly a better asset to retain as the distributions will be tax free. However, there are still rules around when you can access the funds. There are some exceptions including a first-time home purchase, education, or health care expenses to access the funds penalty free earlier than 59 ½, but ideally you would want these funds to grow long term.
In summary, during a divorce, emotions run high, and it is difficult to think clearly about the financial side of the situation. Ensure you have a team of professionals working on your behalf including an attorney and financial professional such as a Certified Divorce Financial Analyst (CDFA) or Certified Public Accountant (CPA) that can help you understand the short and long-term implications of any financial settlement. While both parties may want a resolution as soon as possible, make sure you’re thoroughly reviewing what you will need to sustain your lifestyle after the divorce and the tax implications of any assets you are receiving as well as future benefits such as pension or Social Security.
If you have any questions around the risks related to diversification or if consolidation makes sense for you, please feel free to contact our team.
Bouchey Financial Group has offices in Saratoga Springs and Historic Downtown Troy, NY as well as Boston, MA and Jupiter, FL.