Divorce is one of the most tumultuous life events someone can experience. Add kids to the mix, and it only gets more complicated. The number of decisions that need to be made in a relatively short period of time can be extremely overwhelming, for example:
- Who, if anyone, is keeping the house?
- What is the custody arrangement for the kids (and pets)?
- Who gets to keep going to your favorite coffee spot?
Divorce turns all parties’ lives upside down. It is easy to get emotional and make quick decisions. For example, the majority of negotiations often pertain to the custody of the kids (and fur-babies), with the splitting of assets (investments, real estate, etc.) being an afterthought.
Don’t let yourself—or friends and family members—fall into a position where you aren’t financially stable once the divorce is said and done. Think about the following items when splitting assets during negotiations.
1. Prioritize Liquidity over Sentiment
While your home is likely one of the largest valued assets you own, it is not necessarily the best asset to get in a divorce. All the sentimental ties to your family home can make it feel invaluable, but it does have a market value and likely comes with a mortgage—and possibly a home equity line of credit. Most importantly, it is not liquid. If you need to replace the tires on your car or pay high school tuition, it is more difficult to tap into the value of your home to get cash.
A liquid asset is an asset you can easily, quickly, and cost effectively turn into cash. Think: money market or bank accounts and liquid mutual funds or stocks (with relatively small capital gains) held in a taxable account (formerly joint or now under individual ownership).
Cash flow is also an important consideration as it relates to debt. By limiting the debt you keep after your divorce is finalized, you’ll have more cash available to help you get back on your feet.
2. Understand the Tax Consequences of Your Assets
The assets you own have different tax treatment. Some accounts, called tax deferred accounts, allow the investment income to accumulate without requiring you to pay taxes today. Instead, you pay ordinary income tax on the distributions made during retirement – distributions prior to 59 ½ years old often have penalties associated.
Other accounts, taxable accounts, require you to pay taxes as investment income is earned or when you sell an investment with a gain (meaning you are selling it for more than you paid for it). However, taxable investments do not have restrictions on when funds can be withdrawn, and distributions from the account are not taxable. For a detailed description of these accounts, please reference my "Investment Accounts 101" post.
Having a good mix of taxable and tax deferred assets is key to financial wellness. You will likely rely on the tax deferred accounts to fund retirement and the taxable account to fund current/short-term needs.
- Note: If there are Roth IRA or Roth 401(k) accounts involved, you want half (or more than half) of those assets. Roth IRAs grow tax deferred AND the funds can be withdrawn tax-free after age 59 ½.
Because your income tax status will change (e.g., from Joint to Head of Household or Single), it’s also worth consulting with a CPA or financial planner to review the necessary actions you’ll need to take.
3. Evaluate Your Risk
If you were not involved in the investing process previously, this may be one of the most daunting things you will take on post-divorce. However, it is necessary to invest in yourself and your future goals. Seek out expert advice to figure out how to structure your investments to give you the highest probability of success. (We define success as being able to reach your goals – retirement, new home, funding college tuition, etc.)
Risk can be adjusted by increasing or decreasing the amount of stock market exposure you have in your accounts. The more stock you own, the more return you can expect… but also the more volatility you’ll experience and risk you will take on. We typically recommend taking the lowest amount of risk necessary to reach your goals.
You should also evaluate the cash reserve you keep now that you are a single-led household. You may need to increase your cash reserve to 6-12 months of expenses to account for unexpected cash outflows – new A/C, car transmission, etc. Keeping plenty of cash in your cash reserve will allow your investments to continue to grow for the long-term goals despite life throwing you its best curveball.
Warning: Be wary of “too good to be true” investments. If it feels like there is no down-side, consult a professional—one who isn’t selling the product. There is likely a “catch.”
There is one thing certain of every divorce: it is completely different from any others. While all of these considerations will set you (or your loved one) on the right path, complexities vary from couple to couple, and there will always be additional considerations that need to be accounted for. It is key to your success to find someone who takes a comprehensive look at your financial life AD – After Divorce – and helps you plan for your new life.