CFP®, CDFA® | Divorce Financial Planner and Mediator
Welcome to Part 2 of the ultimate guide to a divorce property division. In Part 1 of the the divorce property division guide, we focused on gathering and organizing all of your information because this is the foundation of your balance sheet or property division.
Now in Part 2, we want to focus on taking things further and show you how to complete a property division option, and more importantly, how do you evaluate a property division to help you avoid making big mistakes.
We like to call this the macro view because you’re taking a step back from the details and looking at the big picture.
Legal Perspective on Divorce Property Division
As a foundational step, it’s important to understand the legal perspective relating to property division options. The legal perspective depends on the state that you live and is looked at two different ways.
Community Property States – property deemed marital is divided 50/50 and property deemed separate or non-marital is not divided as part of the divorce. When there is doubt on how to classify property, it is deemed marital and is divided 50/50.
Equitable Distribution States – property is divided equitably or fairly but not necessarily 50/50. There can be many factors that would cause a property division to not be 50/50. Just because equitable distribution states don’t have to be 50/50, it’s our experience that the majority of families conclude that what is fair, or equitable, is a 50/50 division for their situation. There are a lot of variables that go into this and so legal advice may be needed to help you evaluate this.
Determining what is fair is very difficult because everyone has a different idea of what fair means. This adds to the difficulty of agreeing on a property division.
All states except for Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin follow the principles of equitable distribution. (*talk to an attorney in your state if you are interested in more details regarding this.)
We explain the legal ways that property is divided just so you are aware of how things work.
What can you live with?
Regardless of the state you live, at the end of the day you have to determine what you and your spouse can live with in a property division. The legal stance on how property is divided is only relevant if you can’t make decisions on your own and need to rely on the court of law to help make decisions for you.
Our viewpoint is that you should always start with a 50/50 property division as a baseline and then deviate as necessary. This gives you a starting point to work from and will simplify things for you.
A good perspective to evaluate a property division is to simply ask yourself if you can live with the property division. We say this because there will likely not be a property division that you and your spouse will both be in love with so it just comes down to what you can live with. At least we’ve seen this approach work really well. You, of course, have to determine what works for you.
How To Create Your First Property Division Option
At this point, all of your information should be gathered (see part 1) and the next step is completing a property division on your own.
We recommend for your “first-go” that you simply divide all of the assets and liabilities based on who’s name is on the account or if it’s obvious who will keep an asset or liability. Note that there will almost certainly be a disparity in your property division by doing this but we will come back and fix it. This is just a starting point.
Lets walk through some examples to help you get an understanding of how to do this:
- For the house, put it in the person’s column who would like to keep it. Also, make sure to include the mortgage in their column as well. If the house is being sold, then split the value 50/50 and the mortgage(s) 50/50 as well.
- Divide bank accounts and credit card accounts based on ownership. For joint accounts, divide them 50/50.
- Allocate the investment accounts based on titling or whose name is on them. For joint accounts, divide them 50/50.
- Allocate the retirement accounts based on the titling or whose name is on them. Note that retirement accounts will never be joint.
- Allocate the personal use assets (i.e. cars, etc.) based on who will likely keep or continue to use.
All of your property should be allocated on your property division at this point. There will be most likely be a disparity and that’s fine. The next thing we are going to even things out by evaluating the property division.
How to Evaluate Property Division Options
The main priority in evaluating a property division is making sure it’s equal from a financial perspective. That is, making sure it’s apples-to-apples from a tax, growth, and liquidity perspective. This is crucial. We see the most mistakes happen here.
In a perfect world, all assets and liabilities would be divided exactly 50/50. This would leave you and your spouse in the exact same financial position regarding your property division.
The problem with this is that it can then turn into an administrative nightmare and sometimes impossible to try to divide every single account or asset.
For example, if one of you is keeping the house, how do you divide the home equity? Another example is with vehicles, debts, and retirement accounts. There simply isn’t a super easy way to divide these.
A Simple 3 Step Method to Evaluate Your Property Division
Not all assets are the same. This is the main takeaway you need to know when evaluating a property division option from a financial perspective. The important thing here is that you are able to recognize when there may be an issue.
There are 3 main things that will help you property evaluate a property division option. They are:
- Taxes
- Liquidity
- Growth
If you use these 3 things to evaluate your property division it will help you to account for the 3 most important pieces to any property division.
When evaluating a property division, it should be done to ensure you’re not making big financial mistakes but also to balance that with the interests that you have.
Taxes
This is by far the most common issue that we see and probably most important when evaluating a property division. The bottom line is that not all assets are valued the same. There are certain asset categories that have embedded taxes built into them. Let’s take a closer look.
Is cash in a bank account the same as money in your pre-tax 401k or IRA? The answer is no. Cash in a bank account has already been tax whereas money in a pre-tax 401k or IRA has not yet been taxed.
What this means is that cash is more valuable than the pre-tax retirement dollars as we look at it today.
Let’s take this a little further. Let’s say that you have $100 in cash and $100 in pre-tax retirement. The $100 in pretax retirement will be taxed at ordinary income tax rates when it is pulled out so it’s really worth $75 – $85 after you pay taxes at your actual tax rate when the money is distributed. If the retirement dollars will be distributed as part of the divorce process or in the near future, this is even more critical because you may also be hit with the 10% early withdrawal penalty that the IRS hits you with if you are under age 59.5 years old.
It’s crucial that you’re accounting for this when you complete your property division. There are various ways to “tax impact” your property division to account for taxes in situation where you are trading cash for retirement dollars so that you are comparing apples-to-apples. The key, however, is to simply understand this so that you can identify it when evaluating a property division.
Liquidity
Liquidity during and after the divorce is often one of the most important things to have. Liquidity is cash or an asset that can easily and quickly be converted into cash.
It’s not uncommon for things to be a little tight after the divorce. Having cash on hand can often mitigate some of the initial cash flow crunch as well as give you the cash you need to make a necessary purchases.
As we have already learned, cash is more valuable in today’s dollars than an asset that has taxes embedded in them like pre-tax retirement dollars. That’s how the finances work.
Another big consideration is what are your interests or what’s important to you… Do you need a down payment on a house? Do you need to purchase a car? Are you someone who needs 3-6 months in a savings account to have peace of mind?
The key is that you don’t make extreme decisions. If you need a little more liquidity, that’s fine, just try not to trade all of the other assets for it if you can help it.
Growth
Growth is a factor that is looked at to evaluate your property division over longer periods of time vs. right now in this moment. For the most part, when evaluating taxes and liquidity you are assessing them in today’s dollars. Growth is something you want to use the long-term view for.
The common example of this is trading the house for the retirement account. If you’re the one keeping the house in this example, it may have a big impact on your long-term financial future. The person that kept the retirement account may have a higher net worth in the future than the person who kept the house.
The idea is that certain assets historically have better rates of returns than others. This should be a consideration when you evaluate your property division.
The bottom line to understand is that different assets have different growth potential as you evaluate your property division.
Evaluating Assets Based on Taxes, Liquidity and Growth
Use this “big 3” evaluator to help you understand the growth, liquidity and taxes of each of your asset classes.
Real Estate
- Taxes = Good
- Most people that sell real estate will not incur taxes. If the property is owned individually, you have a federal exemption of $250k on the gain and $500k on the gain of a property owned jointly.
- Liquidity = Moderate
- Selling a house can take time and there are fees associated with doing so. If you have equity in a home, a 2nd mortgage like a home equity line of credit or a home equity loan can be utilized to pull cash out of your house. There are certain rules that apply but generally speaking, it can be a source of cash.
- Growth = Moderate
- The historical real estate growth rate is 3-4%/year a majority of the time.
Bank Accounts
- Taxes = Good
- All of the money in your bank account has already been taxed so it’s tax free. There is an exemption if you’re self-employed.
- Liquidity = Good
- The money can be pulled out today to use however you want.
- Growth = Bad
- Long-term rates of return on bank accounts is less than 1%.
Investment Accounts
- Taxes = Moderate
- You are only taxed on the growth in an investment account. Investment accounts have preferential tax treatment with long-term capital gains which are less than ordinary income taxes.
- Liquidity = Moderate
- The money can be accessed fairly quickly. When selling a stock it can be turned to cash in three days.
- Growth = Bad to Good
- It all depends on the underlying investments. Investors don’t often hold investment account dollars as long as retirement dollars which can be good or bad depending. There are a lot of factors that play into the growth of an investment account.
Retirement Accounts
- Taxes = Bad
- Traditional IRAs and 401K plan withdrawals will be taxed as income in retirement.
- Exception to this is a Roth IRA in which case the money in the account can be pulled out in retirement tax free. This includes principal and growth.
- Liquidity = Bad
- If you liquidate a pre-tax retirement account you will be hit with taxes and a 10% penalty if you are younger than age 59.5.
- Growth = Good
- Long-term rates of return on retirement assets can often be your best source for growth.
Business Interests
- Taxes = Moderate
- A gain in a business interest is often taxed at capital gain tax rates upon sale. As discussed with investment accounts, there is preferential capital gain tax which is lower than ordinary income tax rates.
- Liquidity = Bad
- It is typically very difficult, expensive and time consuming to turn a business into cash.
- Growth = Bad to Good
- Some business don’t do well and some do great.
Personal Use Assets
- Taxes = Good
- There aren’t taxes on person to person transactions such as selling a car.
- Liquidity = Moderate to Good
- It really depends on the personal use asset but there is an active market for things like cars, lawn mowers, etc.
- Growth = Bad
- Most personal use assets such as cars depreciate in value.
Examples of Divorce Property Division Options
Let’s take a look at some simplified real life examples of divorce property division options and use what we’ve learned.
Case Study:
Facts:
- $250k house, $150k mortgage ($100k in home equity)
- $10k in the bank accounts
- $100k in total retirement
Let’s start with looking at an apples-to-apples property division:
This is an example of perfect property division (apples-to-apples) from a financial perspective because both spouses have the same amount of taxes (retirement accounts), liquidity (cash and real estate assets), and growth (retirement accounts) built into each of their situations. The assumption with the house in this example is that it is sold and the proceeds are split 50/50. Obviously, there would be cost associated with the selling the house but to make it easy they were left out.
Now let’s looks a property division that is not apples-to-apples:
In this property division both spouses end up with the same amount of total equity ($105k) but the way it’s accomplished looks a lot different from the first example.
Spouse #1 keeps the house, the cash is split and Spouse #2 keeps both retirement accounts. Let’s evaluate this option using the “the big 3” we’ve learned about.
Taxes:
On the surface this looks like a perfect 50/50 property division where both parties end up with $105k but taxes aren’t being accounted for. Spouse #2 has taxes embedded into $100k of retirement dollars. In today’s dollars the actual value of these accounts is approximately $75k-$85k after taxes (depending on tax rates). On top of that, if the money was distributed today, there would also be a 10% early withdrawal penalty, lowering the value to $65k-$75k.
Spouse #1 on the other hand will not incur taxes if they decide to sell the home. They will, however, have costs of selling the home but they are usually much less than taxes on retirement dollars.
In a real life example, Spouse #2 may plan on distributing some of the retirement dollars for a down payment on a house since Spouse #1 kept the house.
In this specific example, Spouse #1 has better deal when accounting for taxes as you evaluate the property division today.
Liquidity:
Spouse #1 has $100k in home equity which is considered moderately liquid because home equity can be pulled out through home equity loans and can also be sold in a moderate timeframe. Spouse #1 also has $5k in cash from the bank accounts.
Spouse #2 has $100k locked up in retirement dollars that will be taxed and possibly penalized if the money is pulled prior to age 59.5. The only liquidity Spouse #2 has is the $5k in from the bank accounts.
It looks like Spouse #1 has better access to liquidity with this plan.
Growth:
Spouse #2 wins from a growth perspective because they have all of the retirement dollars ($100k). If Spouse #2 keeps the money in the retirement accounts and doesn’t liquidate any of it, their long-term future looks good.
Spouse #1 on the other hand has the house which typically has moderate growth over time.
The Bottom Line with Evaluating Your Property division
It’s important to recognize that not all assets are created equal. The bottom line is that you evaluate the “big 3” based on your individual interests and you won’t make a big financial mistake.
The key is to recognize issues that a property division might present. Then, if you’re savvy enough, you can restructure the property division to account for the issues at hand. If not, we recommend getting help from a financial professional and/or a lawyer that can help you make good sound decisions.
The decisions you make in the divorce process are BIG decisions. Be sure you’re not making big mistakes. By reading this you’re already 95% ahead of most people going through the divorce process.