In divorce, all assets are not created equal, and spouses need to understand how this plays out as their divorce proceeds.
The principal lesson is this: $1,000 of asset X and $1,000 of asset Y on a spreadsheet does not mean that the value of X and Y are equal.
Let’s take a look at some simple economic concepts and how they help explain the difference.
The first concept is present value. It is better to have money today rather than money off in the future because you can invest money in your hands today rather than in the future. This means that cash is the ultimate in present value, while something that depreciates over time may be less so. But to fairly evaluate present value, you have to subtract any costs to convert an asset into cash. We will address that in a moment.
The second concept is opportunity cost. The same amount of money can buy you two different goods, A and B. But which would you prefer? Is there a difference? Yes – the one that gives you more benefit based on your preferences. For example, I may love cars, but do I love them more than my house? To keep the house, I have to give up some of the cars. Or, the cost of not completing my education is the income I would stand to lose from a better job, while the cost of completing my education is the income I lose now from not working. In short, every deal has tradeoffs and you need to rank your preferences based on what you could lose or gain.
Now let’s look at some issues that come up all the time in divorce.
First, should you try and keep the marital home? People don’t like to move, and they may love their house. But if the house has a mortgage and upkeep and taxes and insurance, those costs go with the benefits. You have to ask yourself if you can afford those costs. Also, is it the best investment? How much equity is in the house? How much could it really appreciate over time? If you have to buy out your spouse’s share in the equity, what will you give up? Is that a good trade? Would it be better for both spouses to sell the house, split the net equity, and choose new and more affordable housing?
Now let’s add the next most common asset of value: retirement funds. Would you trade some retirement to keep the house? Is that a good trade? Well, if you do not have lots of your own retirement, and your mutual fund earns more a year than the house, that seems like a bad deal on paper because you are giving up too much future income just to keep from moving or because of sentimental value. That kind of move could cost you tens of thousands of dollars you will need later in life.
Finally, let’s consider the true cost of assets. If you get a portion of your spouse’s retirement fund, and you want to access funds immediately, you will pay a big price. First, you have to pay the early withdrawal penalty, usually 10 percent. Second, you have to pay taxes, because the funds count as income. That could mean you lose more than one-third of the value of the asset you thought was a great deal. Not so great anymore. A low-interest home equity loan would be a better move for short term cash without the cost to the retirement funds, which will also deprive you of future income because you converted to cash to pay bills. Taxes come into play if you sell stocks or sell your house, where you have to worry about capital gains now too.
Bottom line: unless you consider the true cost of an asset or the net value of the asset to you, as well as what you give up to get it in the overall settlement, you will put the wrong value on that asset, and likely overestimate its worth – at your expense. When you remember opportunity cost, you want to think about what you give up by taking one set of assets – is it really worth it long term?