Divorce is stressful enough as it is. When the markets are volatile, it can really add fuel to an already combustible situation. Meeting with your financial expert or attorney during the economic divorce process and seeing the numbers on your estate spreadsheet change can be terrifying, or conversely, comforting (possibly followed by once again terrifying) based on the direction of the volatility at the current moment.
It’s important to understand what you are facing with your estate division – especially in a volatile market. There are no “take backs” in the estate – once you finalize, it’s final. We are hoping this article helps you understand more aspects of your estate and provide information to help you negotiate from a position of power for yourself when markets are volatile.
If you have not been involved with your investments or even if you could use a refresher, I encourage you to start by sitting down with a Certified Divorce Financial Analyst to review each of your economic divorce assets. When you do this review, I want you to understand the following about each asset:
(1) What type of asset is it?
(2) How is the value of the asset determined?
(3) What type of account is it held in?
(4) What does this information mean for you?
(5) How volatile is the asset?
(6) When can you expect to use this asset?
(7) How would the division of this asset affect you?
(8) What are the consequences or benefits of not taking this asset?
It may be cumbersome to learn the basics of what you own, but knowledge is power!! The more you know, the better position you’ll be in to negotiate with confidence.
Understanding Taxation of Your Assets
The cost economic divorce basis is the amount that was initially paid for an asset. Sometimes, the asset was purchased with money that has already been taxed like Roth IRA funds or brokerage account funds. Sometimes, the assets have been purchased with funds that have not yet been taxed such as pre-tax 401k funds. Knowing if your assets have been taxed already or not could save or cost you 10% – 33% off the asset.
Here’s an example. Let’s pretend that a $400,000 investment account is divided evenly. Each of you will receive $100,000 in assets from the portfolio. That seems fair, right? Well, what if the Wife’s portion of the portfolio has a cost basis of $50,000? If the capital gain is taxed at a rate of 15%, the after-tax value would be $177,500. Now let’s assume the cost basis on the Husband’s $200,000 in assets is $150,000 then the after-tax value of his portion of the account is $192,500. Because of the varying cost basis of the assets, the division may not be a fair as it seemed.
Once you understand your assets, you are in a much better position to negotiate. It’s rare that parties decide to divide every asset right down the middle. Instead, parties often negotiate to offset the value of certain assets. For example, one party may want to retain the primary residence in exchange for taking fewer investment assets. When the market is volatile, the date that assets are valued for this division is critical.
For example, if there is $300,000 in equity in the home, one party might negotiate keeping it in exchange for the other party retaining a $300,000 investment account. However, market volatility could drive the value of the investment account down 10% from the time of the initial valuation. At the same time, the housing market could continue to improve another 5%. By the time the divorce is final, the division may not feel as fair. The equity in the home would be worth $315,000 while the investment account would be valued at $255,000. That’s why it’s important to understand the pros and cons of each asset as you negotiate offsets.
Volatile Markets Make Decree Wording Matter
The wording of your divorce decree matters – a lot!! As it relates to your finances, the wording can have a significant impact.
In the earlier example, we were talking about dividing a $400,000 investment account equally, so each party would get $200,000. If the settlement agreement specifically states that $200,000 is awarded to one of the parties and the market increases by 10% from when the account was originally valued, then one of the parties will not benefit from the appreciation in the market and the other party will realize the benefit on the full $400,000. Thus, one party would receive $200,000 and the other party would receive $240,000. The opposite is also true. If the market were to decline 10% and the dollar amount was stated, one party would still get their $200,000 while the other would receive $160,000.
You can see why the wording of an economic divorce is so important. If the intention is for the account to be divided in half, then be sure your agreement says so and does not use a specific dollar amount. Language around how market gains and losses should be handled should also be included. It can often take months for all accounts to divided following a divorce and there can be significant market fluctuation from the date of division listed in your agreement to the date in which your assets are divided.
Likewise, if you are really counting on a certain dollar amount to cover basic living expenses or a down payment on a house, you may want to forego any market returns to be sure you end up with the money you need. In that case, you’d want a set number listed in your divorce decree. The key is to make sure that the language in your agreement accurately represents the intent of your agreement.
Do You Need Help Understanding the Financial Impact of your Estate Division and the Wording Proposed in Your Decree?
While we are in Houston, Texas, we work with clients virtually nationwide. If you need assistance understanding your financial picture, what your options are, and/or a plan for your future, contact us for a complimentary consultation. We are committed to educating and empowering clients to make wise financial decisions.