Anyone who's gone through divorce knows how difficult it is. With your entire life in flux, you may be tempted to put your finances on the back burner in favor of more pressing emotional concerns. Yet mistakes made at this crucial time can have a major impact on your financial situation for years to come. With so much at stake, it's important to think through all of the issues at hand and make sure that you are comfortable with the way you choose to resolve them.
Dividing property and debt
The division of property at divorce has provided plenty of fodder for Hollywood cinema, but in real life, being an actual participant in the process removes any semblance of comedy from the process.
In dividing property, you must be realistic about what your financial situation will be after the divorce. For instance, in today's overheated housing market, it's common for couples to need two incomes to support a mortgage payment. As much as you may want to keep your home for yourself for personal reasons, neither of you may be able to afford it alone. Similar considerations apply for other expensive property, including vehicles and vacation property.
On the other side of the balance sheet, make sure that you know about all of the debt that your spouse may have incurred during your marriage. In too many cases, spouses find out about an outstanding debt years after divorce, only to discover that their own credit is at risk. Be aware that state laws differ about whether one spouse is responsible for the debt of the other, but the best course of action is to discover everything at the time of the divorce and deal with it specifically in your property agreement. In some situations, the spouses can choose to assign responsibility for certain debts to one spouse or the other.
Only by understanding both your past financial condition as a couple and your present financial condition on your own will you be in a position to negotiate wisely.
Alimony and child support
As with many things, legal proceedings dealing with divorce introduce a number of unfamiliar terms to one's vocabulary. In simplest terms, alimony, maintenance, and child support all mean one thing: money that one spouse pays to the other. However, they are usually treated differently for federal income tax purposes. Unless the spouses designate otherwise, alimony -- payments one spouse makes to the other specifically for the spouse's support -- is usually treated as taxable income to the spouse who receives it, and the spouse who pays it can deduct it from income. However, there are complicated rules that may limit such deductions, especially when the divorce decree calls for a single lump-sum payment rather than ongoing monthly payments.
In contrast, child support is neither considered taxable income to the receiving parent nor deductible by the paying parent. As a result, how payments are allocated between alimony and child support can make a substantial difference in the net amount available to the recipient spouse after tax. Make sure that you understand what a potential settlement will mean to you both immediately and on an ongoing basis before you decide whether to accept it.
The formalities of disentangling
Even after your divorce decree is final, you will need to make sure that you complete all the necessary paperwork to give it full effect. This includes removing a former spouse's name from formerly joint bank and financial accounts, changing your named beneficiary on insurance and retirement plans, and updating your estate-planning documents to make sure your assets go to the people you want to receive them.
In addition, consider taking some of the same steps that victims of identity theft take, such as changing credit card and bank account numbers, changing passwords for online accounts, and monitoring your credit report on a more frequent basis. Because many couples run their finances as a single family unit, a malicious ex-spouse could gain access to your personal financial information, especially since your ex-spouse will know your most common security information, such as your Social Security number, birth date, and mother's maiden name. Be as vigilant as your particular situation calls you to be.
For couples in which there is a large disparity in incomes, retirement planning becomes an essential component of a divorce decree. Often, a huge percentage of a family's financial assets will be tied up in a company retirement plan. Because this situation occurs so frequently, the rules dealing with taxation of retirement plans have specific provisions for obtaining what is called a qualified domestic relations order, or QDRO -- pronounced "quad-row."
Under the QDRO rules, a property settlement can divide a retirement plan into two parts, one for the employee and one for the employee's divorcing spouse. Unlike a typical retirement-plan distribution, this division does not create immediate tax liability; instead, the ex-spouse is usually treated in the same way that other plan participants are, with the same investment and distribution options. Speaking with the company-benefits specialist is often the best source of information about your options.
An ounce of prevention
Paradoxically, the best time to learn about the things you'll want to know in the event of divorce is before the threat of divorce arises at all. The people who tend to be most nervous and uncertain about how their finances will work after divorce are those who played little or no role in managing the family finances during marriage.
By making sure that you understand how your family's finances work, not only will you be able to deal with a divorce more rationally, but you may also avoid divorce entirely, having removed or lessened the impact that financial matters have as a primary cause of stress among couples.
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This article was originally published on June 14, 2006. It has been updated by Dan Caplinger. The Fool has a disclosure policy.