John and Susan are very typical clients we see in our office regularly. They are educated. John makes a good living as an MBA who works downtown at a financial firm. Susan was a stay at home mom for a while but has a degree in marketing and has recently re-entered the work world. She currently makes a fraction of what John makes, but that is expected to grow over time. They are knowledgeable about what they own and what they owe. They, logically, assume dividing their estate will be simple. How many times have we heard; my divorce case is simple? While logically it may seem simple, it’s usually not in reality. In addition, tax issues may slant a 50/50 division into more of a 60/40 division – which can cause very hurt feelings a few months after the divorce. Their mediation in Texas could have gone very different ways.

Here is an example of a ‘simple’ divorce that proves to not be so simple and how this 50/50 division went very wrong.

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The Estate

John and Susan own the following:

Primary Home: $750,000 Value, Mortgage Balance $350,000 = Net Equity $400,000
Secondary, Vacation Home: $400,000 Value, No Mortgage
John’s 401k: $450,000
Checking & Savings: $50,000
Total Net Assets: = $1,300,000

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Their Solution

Their kids are grown, and Susan determines that she cannot really afford the primary home on her own. So, John takes the primary home and Susan takes the secondary home. Susan is 53 and wants to stay close to their kids in Texas so she decides to sell the vacation home to purchase her own home. John initially decides to stay in the primary home for a few more years and then sell it down the road to downsize. This is the logical division of assets the couple decides to do:

John: Primary Home: $400,000 Net Equity
John: Half the 401k $225,000
John: Half the checking $25,000
John Total: $650,000

Susan: Secondary Home: $400,000 Net Equity
Susan: Half the 401k $ 225,000
Susan: Half the checking $25,000
Susan Total: $650,000

A perfect, 50/50 split right! No problem. This is simple. Well, it is on paper, but this 50/50 is really a 62/38 division after taxes.

The Reality

John decides he doesn’t want such a big house to upkeep, so he sells it right after the divorce is final. John sells the primary house for $760,000. He pays off the now $345,000 mortgage and pays 8.5% ($64,600) in closing costs and realtor fees for a net equity of $350,400. They purchased the house 10 years prior and put $300,000 down the home and added a pool for $50,000. His net cost basis in the home is $350,000. He has zero tax liability as he has $250,000 exemption as a single person.

Susan sells the vacation home and purchases a new residence for herself. She is only 53 so she is going to take advantage of the opportunity to withdraw funds from her spouses 401k in divorce without the extra 10% penalty, but she still owes tax on the withdrawal. She does this for a financial safety net while she re-establishes her career. Susan sells the secondary home for $405,000. She also has 8.5% in closing costs or $34,425. The property had been purchased for $170,000 and $30,000 was put into a new back patio so her basis in the home is $200,000. Susan assumes her gain of $170,575 is well under her personal exemption amount of $250,000. When tax time comes around the next year, her accountant looks at her with big eyes and breaks the bad news. The personal exemption is only applicable to a primary residence and you must live there for 2 years in order to use it. Since she didn’t, the entire $170,575 is taxable at 15% netting her $144,989. Let’s not forget, Susan doesn’t have the income that John has so she takes $100,000 of the 401k and moves it into cash and the other $125,000 she moves into an IRA for herself. The $100,000 is treated like ordinary income and taxable to her. She owes $28,000 in taxes off the 401k funds she took in cash.

This is what each party really kept in the divorce:

John: Primary Home: $350,400 Net Equity
John: Half the 401k $225,000
John: Half the checking $25,000
John Total: $600,400

Susan: Secondary Home: $144,989 Net Equity
Susan: Half the 401k $125,000 into an IRA plus $72,000 cash from the 401k, the remaining $28,000 goes to the IRS this year for taxes
Susan: Half the checking $25,000
Susan Total: $366,989

Total Tax Effected Estate: $967,389

The net effect is not a 50/50 – within one year of the divorce, given the withdrawals that were taken, they had a net tax effected estate of $967,389. John receives $600,400 or 62% while Susan receives $366,989 or 38%.

There are, typically, no do overs in the final estate division. If Susan had known what was going to happen with the primary home and the secondary home net of taxation – she may have not been so eager to agree to this in a mediation in Texas. Further, if she knew the tax ramifications of taking funds out of the 401k, she may have discussed taxation a little further before determining the 50/50 division or have asked for support of some kind to offset this taxation hit in today’s dollars. A Certified Divorce Financial Analyst could have really helped uncover these issues before a Mediated Settlement Agreement was signed in mediation in Texas or before the divorce negotiations were finalized.

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Your Reality

If you and your spouse are entering a do it yourself divorce, we commend you on trying to hash this out cooperatively rather than in a long, drawn out battle. However, it’s important to consult with professionals before signing anything. It is wise to review your estate division with a Certified Divorce Financial Analyst who can walk through financial pitfalls, such as taxation, in your divorce settlement. At Divorce Strategies Group we understand divorce financials, we understand divorce mediation in Texas, and we can help. Call us at 281-210-0057 or schedule a strategy session today to get started!