Divorce can be one of the most stressful changes in your life. It’s common for just one party in a marriage to be responsible for all the finances. Even if both parties are aware of the day-to-day finances, it’s even more common for only one party to handle all the investments.
The combination of learning about your investments for the first time and watching the value of those investments decline in a volatile stock market can be overwhelming. How does a declining stock market impact your divorce settlement agreement? And as you look beyond the divorce, what do those declines mean for your longer-term financial future?
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 (CDFA) to review each of your 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) Do you need the cost basis of the asset and if so, what is it?
(5) How volatile is the asset?
(6) How liquid is the asset?
(7) What is the cost and what are the tax consequences of liquidating the asset?
(8) How is the asset titled?
(9) What documentation is required to change how the asset is titled?
It may be obvious to you why you need to be able to answer these questions, but it may not be, especially if this is the first time you are learning about these assets. One issue that often surprises me when it is forgotten during negotiations is cost basis.
Cost basis can have a big impact on the after-tax value of your assets. As you consider each asset for division, it’s important to understand how it is taxed. If you are dividing stocks in an after-tax account, you’ll need to know the cost basis of those investments. The cost basis is the amount that was initially paid for each of the stocks. Let’s say you decide to evenly divide a $400,000 investment account. If you agree to take more of the assets with a low cost basis, you will receive less value on an after-tax basis because you would be responsible for a larger share of the capital gains taxes if/when the stocks are sold. Likewise, if one party receives more of the assets that are closer to the original purchase price, there will be less capital gains tax on the sale of the assets.
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, even in a community property state, where the marital property is shared 50-50. (For additional information about what is considered marital vs. separate property, see our post on the topic: What is considered separate property in a divorce?)
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 really important to understand the pros and cons of each asset as you negotiate offsets.
The control you have over when the assets are valued is determined by the process you use to terminate your marriage. If you choose to litigate your case, the Court will ultimately determine the date of valuation.
I’m sure that you know it’s always important to pay close attention to how your divorce settlement agreement is worded. That’s why I always encourage all clients, even those filing pro se (without an attorney), to at least have an attorney review their paperwork. 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 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 actually 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. The key is to make sure that the language in your agreement accurately represents the intent of your agreement.
While we are located in Ohio, 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.