The process of divorce can be emotionally painful, especially if it’s a bad breakup. But even with amicable splits, divorce can be financially taxing on both parties. Issues such as child support, spousal maintenance, and division of assets can be stressful and financially ruinous.
After nine years of marriage, Arthur Vaughn of Englewood, Colorado, got divorced in October 2003. Nearly a year later, Vaughn is still struggling to recoup from the settlement. “I have been able to save very little money,” says the 33-year-old manager for Arcadia Financial, a credit collection division of Citigroup.
Part of Vaughn’s concern is that he took on most of the debts in the settlement -one of their two homes, a 2002 Jaguar, and various credit cards. “I kept my 401(k) and my pension,” he deadpans. “She got the first home with all the equity and furniture.”
Before the divorce, Vaughn says he had about $2,500 in savings and $25,000 in his 401(k). He now has about $1,500 in a mutual fund, $1,000 in savings, $1,000 in a checking account, and about $5,000 in his retirement account. “I took out a withdrawal from my 401(k) to maintain living expenses,” says Vaughn, who was contributing 12% of his salary. As a result, his account was suspended for a year, in accordance with company policy. “I can’t contribute to it again until November 2004.”
Then there’s the financial responsibility of three children. Vaughn and his former wife, Colette, have joint custody of their son, 4, and daughter, 7. The couple also cares for Colette’s 11-year-old daughter from a previous relationship, who was an infant when they married. Vaughn pays $561 a month for child support. As part of the settlement, Vaughn had to pay out a total of $11,300 in alimony. Up until July, he paid about $600 a month.
Vaughn kept the second house, which was purchased in August 2001 for $275,000 at an interest rate of 7% ($260,000 remains on the mortgage). For more than a year, he lived in the 3,100-square-foot home. “I couldn’t afford to stay there and maintain the [$2,200] mortgage payment,” Vaughn says. This past March, he moved into a two-bedroom apartment, paying $850 a month in rent while he leases out the house. “My monthly expenses are about $3,400. My take-home pay is about the same. So, I am basically tapping out,” he says.
While the young professional says he spent the first years of his marriage helping pay off his former wife’s $20,000 in debts, he concedes, “My idea of success was acquiring nice things -a house, a car. Looking back, I was working to buy, buy, buy … to keep up.”
Vaughn is currently in graduate school pursuing a master’s in business administration. His employer is footing half of the $20,000 tuition bill. “Once I get my M.B.A. [in May 2005], I am hoping my salary will increase by 15% to 20%. I’m also getting my project management certificate to set me up for something more lucrative.” Vaughn’s annual gross salary is $60,000; as a licensed realtor, he also earns $15,000 a year in commissions from working with a broker.
“My goal when I was married was to buy five or six properties and liquidate them to pay for our kids’ college education. I see real estate as a passive investment with long-term gain,” he says. “I want that to be a big part of my portfolio, much like my dad. That’s how he did it -he made money by renting out properties.”
In a divorce, the basic divvying up of property is equitable distribution (or community property under some states). Assets, earnings, and debts are split fairly, although that doesn’t necessarily mean that they are split evenly. The spouse with the higher earnings can get two-thirds of the assets, but also acquire more of the debt. One of Vaughn’s biggest mistakes was not notifying creditors and the three major credit bureaus that he was in the middle of a pending divorce. Another mistake was not removing his former spouse as his beneficiary, says Michael M. Smith, a certified financial planner based in Phoenix.
BLACK ENTERPRISE asked Smith to consult with Vaughn and help him map out a new game plan for financial life after divorce. The following are his recommendations. In addition, an estate planning attorney, Lori Douglass of Kurzman, Eisenberg, Corbin, Lever and Goodman L.L.P., weighed in on some of the legal issues that Vaughn is facing:
Lease with the option to buy a house. Vaughn’s apartment lease is up in October. He should look for a home or town house that he can lease, for about the same amount he is renting, with the option to buy. The advantage is that you don’t have to pay the 20% down payment right away. In fact, you can negotiate with the owner that a portion of your lease payment be accumulated and applied toward the down payment for future purchase of the home.
Create a single-member limited liability company. Vaughn currently owns a home, which is listed on his tax return, under a schedule E, as rental income. He should form an L.L.C
and transfer the home to the newly formed L.L.C. Have the L.L.C. taxed as a sole proprietorship. When he purchases the next property (or properties), he should put it into the L.L.C. This way, the passive income or losses he would have had become ordinary income or losses. Also, there are special ownership allocation rules with an L.L.C. that would allow him to apply income to the children, but all the tax appreciation would go to the father. This way, the children would have ownership and interest in the property, which could be used to fund their college education.Buy more life insurance coverage and establish an irrevocable life insurance trust. Vaughn needs at least $750,000 in term life insurance. He should split the beneficiary arrangement between the three children. Since he is divorced with children, he needs to set up a life insurance trust. By doing so, he can designate a guardian to oversee the insurance proceeds and other assets. If he leaves the death benefits directly to the children, his former wife would automatically get it as their guardian. Also, the trust will protect his children should he remarry. In addition, he needs to draft a will.
Douglass recommends that Vaughn draft a will to establish guardians in the event that he and his former wife both pass away, as well as set up a trustee to handle his finances. Also, by identifying a power of attorney, there would be someone in place if he became disabled.
Invest an extra $600. Since he no longer pays alimony but is accustomed to shelling out about $600 monthly, Vaughn should apply that money toward his investment plan. He is currently putting $100 each month into a
Smith Barney aggressive growth mutual fund. However, he should consider investing in a mid-cap or small-cap value fund. This way he can minimize volatility in his portfolio and move toward value without sacrificing growth. He should invest the $2,000 cash prize in these types of mutual funds.Build liquidity to purchase rental properties. Vaughn needs to build liquidity while paring down debt. He still has about $15,000 in credit card debt that he is adamant about paying off. Unless he begins to build up his cash reserve, he will simply increase his debt. Vaughn admitted that his spending habits hurt his savings plan. So, if he still wants to acquire rental properties and follow in his father’s footsteps, he could buy a house below market value and fold his debts into the new mortgage.
Consult with former wife about claiming both biological children. Vaughn currently claims one child as a dependent on his tax return. Since he is earning practically twice as much as his former wife, and is in a higher tax bracket, he needs the tax savings -in this case, $5,000 -more than she does. She can still use her home as a tax write-off. Plus, as head of household, she can continue to claim her daughter and get the earned income credit.
In the event that he decide
s to remarry, Smith says, Vaughn should consider a prenuptial agreement to safeguard the assets he brings into the marriage. The agreement should be coordinated with his insurance policy, will, and trust documents.
Vaughn should have a prenuptial agreement to negotiate for whatever he’s going to leave his children “if that’s going to exceed half his estate,” Douglass says.
|
HOUSEHOLD INCOME |
|
| Full Time | $60,000 |
| Part Time | 15,000 |
| Total | $75,000 |
|
ASSETS |
|
| Checking | $1,000 |
| Savings | 1,000 |
| Mutual Fund | 1,500 |
| 401(k) | 5,000 |
| Market Value of Home | 310,000 |
| Value of Car* | 15,000 |
| Total | $333,500 |
|
LIABILITIES |
|
| Mortgage | $260,000 |
| Credit Card Debt | 15,000 |
| Auto Loan | 21,000 |
| Student Loans | 10,000 |
| Total | $306,000 |
| NET WORTH | $27,500 |
| *ACCORDING TO KELLEY BLUE BOOK. | |