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Five Tests Every Divorce Settlement Must Pass
“They say marriages are made in heaven. But so is thunder and lightning”
- Clint Eastwood
So after weeks and months of negotiation, sleepless nights, and too much Pepto-Bismol you have finally come up with a divorce agreement you are happy with.
After all, you got the house, more than half the assets, and the antique dining room furniture that makes you feel like you are in Paris at dinnertime. You are ready to sign on the dotted line and get on with your life. But is it really a good settlement for you? Here are five tests every good divorce settlement must pass.
It Is Based on Economic Reality
Family finances are not simple. Some expenses are easily identified like the mortgage and the cable bill, but many others are not such as the kids’ allowances, and your $8 daily lunches. And projecting the budgets for two separate households adds more complexity. So it is imperative that the data on which you are basing your agreement reflects your actual financial life.
I recommend my clients take a year’s worth of all expenses and categorize each one so they can get a clear picture of where their money goes, and then assume those expenses grow each year by 5 percent. A cash flow analysis from your financial coach is very helpful in projecting into the future how each household would fare under a proposed settlement.
Other numbers that need to pass the reality test are growth assumptions for your investment and retirement accounts, and for inflation. A major flaw of most divorce financial planning tools is that they use long-term averages to predict the future value of securities as if you get that return consistently every year. Unfortunately markets do not work that way, so your projections could be an overly rosy view of your financial future. Keep estimates conservative and you will be well served.
Your 50% Is the Right 50%
If you have gone through the exercise of establishing your vision, defining your strengths and weaknesses, and determining your “must haves,” you should be in a position to negotiate an agreement that helps get you what you need most.
Dividing up marital assets is not the same as taking a cake and simply cutting down the middle. That is because your family’s net worth is really made up of a lot of different things ranging from real estate to checking accounts to your living room furniture. You can’t sit on a checking account, and you can’t buy groceries with the family heirloom so you need to make sure the assets you end up with are the ones that support your specific needs.
As an example, if your agreement gives you the family home in exchange for 401(k) or savings accounts you may find yourself with too small of a cash reserve for paying unexpected bills and maintaining the property.
If you have excellent cash flow from work or other sources this may not be an issue. But in the end, you want your agreement to provide adequate and reliable income to pay your bills, access to a cash reserve for emergencies, a place to live that you can afford, and assets set aside for your retirement and education expenses.
This is an oversimplification, of course, but many agreements fail to provide one or more of these requirements.
Assets Are Valued Accurately
When your financial life is laid out on a piece of paper it has the appearance of accuracy. In my experience some of those numbers are guesses at best, and others are downright misleading.
One common mistake is not adjusting the value of 401(k) and retirement accounts to account for taxes due at withdrawal, which can lower their real value by up to 40 percent. We have a chapter on that coming up.
Other heavily taxed assets that may be overstated are stock options and deferred compensation plans. Pension plans because of their complexity require special analysis so they are fairly valued both in today’s dollars and as a future income stream. Lastly, home and business market values need to be properly appraised by trained professionals.
Spousal and Child-Support Commitments Are Insured
If your settlement has significant income commitments in the form of child or spousal support it ideally should be backed by an insurance policy on the life of the payer. A simple term insurance policy owned by the person receiving the income is a way of making sure you have the financial support you are counting on. This is discussed in detail in chapter 19.
It Passes the Stress Test
Despite the care and attention some agreements are given to “get the numbers right” we have to concede that there is a lot of estimating going on. So it pays to “stress test” your agreement to see if it still passes muster if things go wrong. A stress test begins by adjusting a few core assumptions beginning with how your expenses and assets will grow over time. If your expenses grow twice as fast as you expect, and your investments earn half as much, what is the resulting long-term impact on your finances? If you suffer a setback through job loss or an unexpected expense, will your settlement give you the resources to deal with it?
This article is excerpted from “The Financially Smart Divorce”
Rhode Island family law recognizes common law marriages.
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