Divorce Financial Mistake #2

At Reliance Financial Services we have created a series of posts called “Avoiding Financial Mistakes During Divorce”.  This series covers the most common financial mistakes made in divorce settlements and mediated agreements.  We are covering some of the most common financial mistakes to illustrate why it is important that individuals review their overall financial picture and long-term ramifications before signing the divorce settlement agreement.  Once the divorce settlement agreement is finalized it can be very difficult to modify.

Divorce Financial Mistake #2: Thinking the value of the retirement accounts is equal to the value of the non-retirement accounts

It is important for individuals to realize that the money in a retirement account is not the same value as money in a non-retirement account (such as a savings account).  This is because retirement accounts are most often funded with pretax dollars.  Put simply, this means that the pretax dollars that go into the employee’s retirement account did not have income taxes taken out.  Likewise, if the employee’s company contributes any amount to the employee’s retirement account then that money is also placed in the retirement account without income taxes taken out.  Money in the account is considered “tax deferred” because the employee has deferred paying income taxes on the contributions until he or she begins withdrawing the money during retirement.

Special note:  The Roth 401(k) is still a fairly new alternative that some employers have made available to their employees.  A Roth 401(k) is different than a traditional 401(k) because the employee’s contribution to the Roth 401(k) is made after income taxes have been taken out.  It is important to understand that while the employee’s contributes to the Roth 401(k) are made with after tax dollars the employer’s contributions are still made on a pretax basis.  Therefore, when funds are withdrawn during retirement, a portion of the funds will be included in the retiree’s taxable income.  Income taxes will be due on the portion that was contributed by the employer.  In this instance the value in the retirement account is still not the same as the value in a non-retirement account.

Below is a list of the most common retirement accounts:

  • 401(k)
  • Roth 401(k)
  • IRA
  • Roth IRA
  • 403(b)
  • 457(b)
  • SEP (Simplified Employee Pension)
  • SIMPLE (Savings Incentive Match Plans for Employees)

So you may be asking yourself: “Why is it important to understand that the money in a retirement account is not equal to the money in a non-retirement account?”  Simply put, the money in a non-retirement account such as a checking, savings, money market, and individual investment accounts have been funded with after tax dollars.  This means that when the money is withdrawn from these accounts there will be no income taxes due because the accounts were funded by after tax dollars.

To illustrate the importance of this difference we will use an extremely simplified example.

Case Study: John and Mary

John and Mary have been married for 10 years.  They have decided that going their separate ways is the best option for them – they have decided to divorce.  They have no children, no debt, and they rent a house.  They both make $50,000 per year, they have $100,000 in a joint savings account, John has $66,000 in his 401(k), and Mary has $120,000 in her 401(k).  For simplicity sake, we will also assume that the value in the 401(k) is all due to contributions; therefore, we are assuming that there has been no appreciation or growth of the retirement funds.  John and Mary were married when they both started contributing to their retirement and savings accounts.  All of their assets are considered marital property. The chart below illustrates John and Mary’s assets.

John and Mary's Marital Assets

 

 

 

Scenario 1 Property Division:

We assume that John keeps his 401(k), Mary keeps her 401(k) and the joint savings account is divided to equalize the division of property.  This is what the division of property would look like:

Scenario 1 John and Mary Divorce Settlement

From a dollar perspective it looks like everything is equal and fair.  However, in the long-term, this settlement scenario is not equitable.  If we assume that both John and Mary are in the 15% federal income tax bracket at retirement then:

  • John’s future income tax liability (without considering capital gains tax on the growth of the 401(k)) is $9,900. This means that in today’s dollars John’s half of the marital property is really worth $133,100.
  • Mary’s future income tax liability (without considering capital gains tax on the growth of the 401(k)) is $18,000. This means that in today’s dollars Mary’s half of the marital property is really worth $125,000.

Mary’s portion, in today’s dollars, is worth $8,100 ($125,000 v $133,100) less than John’s.

Scenario 2 Property Division:

We assume that John and Mary should each have the same amount in retirement assets and then split the joint savings account.  This is what the division of property would now look like:

Scenario 2 John and Mary Divorce Settlement

In this scenario, Mary would transfer $27,000 of her 401(k) to John through the use of a QDRO (Qualified Domestic Relations Order).  From a dollar value perspective it looks like everything is equal and fair.  If we assume that both John and Mary are in the 15% federal income tax bracket at retirement then:

  • John’s future income tax liability (without considering capital gains tax on the growth of the 401(k)) is $13,950. This means that in today’s dollars John’s half of the marital property is really worth $129,050.
  • Mary’s future income tax liability (without considering capital gains tax on the growth of the 401(k)) is $13,950. This means that in today’s dollars Mary’s half of the marital property is really worth $129,050.

In this scenario the property division, after income taxes, is $129,050 for both John and Mary.

Summary

This example, although extremely simplified, serves as a clear illustration of how important it is to understand the overall financial picture, and long-term impact, associated with the division of property.  In this scenario, many attorneys, mediators and individuals may think that a CDFATM isn’t necessary since John and Mary’s situation seems simple.  However, a CDFATM assists attorneys, mediators and individuals in understanding both the short-term and long-term impact of proposed settlement scenarios.  A CDFATM would have only cost a fraction of the money that Mary saved in future taxes.

A Certified Divorce Financial AnalystTM assists attorneys, mediators, and individuals in avoiding the most common financial missteps throughout the divorce process.  A CDFATM has been specially trained and is skilled at performing the necessary analysis that will help determine the tax implications and fairness of proposed property division scenarios.  By adding a CDFATM as a member of the divorce team, an individual can understand the short-term and long-term ramifications of dividing retirement and non-retirement marital property.

If you are unsure your divorce options or whether the services of a CDFATM are right for you then please contact us.  We would be happy to help you determine if such services are right for your individual situation.  You can also learn more about your options and divorce financial planning by visiting the St. Louis Divorce and Mediation Services website where you have access to additional divorce information.

Going through a divorce is a very trying and emotional time for many individuals. Sometimes it helps to be surrounded by others that are going through the same thing as you.  If you would like to find a Divorce Support Group, in your area, please visit the DivorceCare®  website.  The support groups are open to anyone and the majority of them are free.

Disclaimer: All articles/blog posts are for informational purposes only, and do not constitute legal or tax advice. If you require legal or tax advice, retain a lawyer or CPA licensed in your jurisdiction. The opinions expressed are solely those of the author, who is not an attorney or a CPA.

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