The Deadweight Loss of Divorce
Posted on Monday, March 28, 2022
In the study of economics, the term ‘deadweight loss’ is a measure of lost economic efficiency when the optimal quantity of a good or a service is not produced. In other words, it’s some value which neither producers nor consumers benefit from. Poof! Value evaporates into thin air, though on the surface value appears optimized between parties Divorce is a situation in which deadweight loss is often realized… especially based on recommendations from well-meaning divorce attorneys negotiating the ‘max’ settlement for their client. Isn’t divorce hard enough without creating additional financial losses?
As financial advisors, we often collaborate with both parties in the process of separating assets as a marriage is dissolved. Our approach is different than most; by understanding the separate future goals of each party and the taxable profile of each asset, we can preserve the biggest possible ‘pie’ to split. A bigger pie means more assets for everyone, regardless of the percentage split. How does this work?
Legal mandates vary by state, but regardless of where you reside, understanding how to minimize taxes is an important angle. If one spouse is the primary earner, and the other has little or no income, the difference in new effective tax brackets creates an opportunity to lower the overall tax bill. Consider a couple with a single earner whose prior tax status was ‘married filing jointly’ with a 25% effective tax rate. After divorce, the spouse with little to no income could realize an effective rate of 10%, or even less, as a single filer. Remember, taxes are based on income, not wealth. This creates an opportunity to sell low-basis holdings that would otherwise be taxed at the other spouse’s higher rate. If assets must be sold as a joint asset or solely by the higher earner, the proceeds will be reduced—a smaller pie.
Another area that creates deadweight loss is liquid versus non-liquid assets. If one spouse receives a home, but limited liquid assets to pay for taxes and maintenance, they wind up with a deadweight asset. This can result in the need to sell assets, possibly even the home, due to cash flow constraints rather than strategic decision making. Or, if a spouse receives retirement accounts that can’t be accessed without penalty, then those assets are essentially illiquid as well. Another example is a retirement account subject to required minimum distributions (RMD) holding illiquid assets, meaning the RMD had to paid out of cash… which the receiving spouse may not be able to afford. An illiquid asset that requires cash input? Major deadweight loss! It’s imperative to identify this problem before the assets are split, because it can’t be changed after the decree is settled. Simply splitting the value of assets without considering liquidity can create bigger problems down the road.
Our view on divorce is that optimizing your future after the divorce is more important than being the ‘winner’ in the divorce transaction. Consider all parties, especially those of mutual interest including children and grandchildren! Divorce doesn’t dissolve the desire to individually provide monetary gifts, future inheritance, college funds, etc. If thousands of dollars evaporate in the form of taxes just because of a divorce, how is anyone ‘winning’ besides the government? So, before you work with a divorce attorney to develop an asset split, consider collaborating with a financial advisor (preferably a Certified Financial PlannerTM) who can optimize the total pie of assets and limit deadweight loss to heartbreak, not financial well-being.
Disclosure:
994 Group, LLC does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachments) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing, or recommending to another person any tax-related matter. Please contact us if you wish to have formal written advice on this matter.
