Achieving Equitable Financial Settlements in Divorce: A Guide by Wooster Corthell

Wooster Corthell |

Divorce can be a complex and emotionally charged process, especially when it involves dividing significant financial assets. It's crucial to understand the different tax treatments of various accounts to ensure a fair settlement. Wooster Corthell Wealth Management guides individuals through these challenging times, ensuring that financial fairness is achieved. Here, we explain how we can assist in understanding the implications of tax-deferred, tax-free, and taxable accounts in a divorce situation.

Understanding Different Account Types

  • Tax-Deferred Accounts: These include traditional IRAs and 401(k)s, where contributions are made pre-tax, and taxes are paid upon withdrawal.

  • Tax-Free Accounts: Examples are Roth IRAs and Roth 401(k)s, where contributions are made with after-tax dollars, and withdrawals are generally tax-free.

  • Taxable Accounts: These are regular investment accounts where capital gains tax is applicable upon sales and all income is taxable in the year received.

The Implications in a Divorce Settlement

Consider this scenario: In a divorce settlement, one party is awarded $50,000 to compensate for unnecessary legal fees that were paid with after-tax money. To pay this, the offending party offers $50,000 from their 401(k) to settle the money owed. The question is, is this proper payment?

First, we need to realize that $50,000 was paid with after-tax money. All spending comes from after-tax money because our income is taxed when we receive it. For example, if we assume a 20% tax rate, to spend $50,000 one would need to earn $62,500. This is because $62,500 * (1-20% tax) is $50,000.

Next, funds in a 401(k) are generally pre-tax. That is to say, taxes have been deducted from the value and therefore, taxes are owed upon withdrawal. So, this means an offer of $50,000 using the same 20% tax rate would be $40,000 after tax!

In our view, this would not make the client whole because when adjusting for taxes, the recipient wouldn’t have enough funds to cover the cost owed to them.

There are generally two ways to solve this:

  1. The payment could be made with $50,000 from a savings account as those funds are after tax.

  2. The payment could be made with $62,500 from the 401(k), which would account for the taxes.

How Wooster Corthell Can Help

At Wooster Corthell, we understand these nuances and can assist in evaluating the true value of each asset in a divorce settlement. Our approach involves:

  1. Detailed Analysis: We thoroughly analyze the tax implications of each financial account awarded or retained during the divorce.

  2. Fair Valuation: We help in calculating the 'real' value of each asset post-tax to ensure it is an equitable split.

  3. Strategic Advice: We provide strategic advice on how to split assets in a way that is equitable and tax-efficient for your situation.

  4. Future Planning: We also assist in planning your financial future post-divorce, giving you the best opportunity for a stable and secure financial path ahead.

Divorce proceedings require careful consideration of financial assets, especially when different types of accounts are involved. Understanding the tax implications is crucial to ensure the division of assets makes sense for your situation. At Wooster Corthell Wealth Management, we are committed to providing our clients with the expertise and support they need during these challenging times.

Please note: We work in conjunction with your divorce attorney or mediator and are not a replacement for them. We simply look at things from the perspective of how this will impact your wealth and ability to retire when the divorce is ultimately behind you. Wooster Corthell does not act as an attorney, and this should not be construed as legal advice.

If you are navigating a divorce and need advice on financial asset division, follow Wooster Corthell Wealth Management on LinkedIn for more insights or schedule a meeting with us for personalized advice tailored to your unique situation. Together, we can ensure that your financial transition is fair, well-informed, and aligned with your future goals.