How a High Earner Can Rebuild Assets Post-Divorce
Divorce is one of the most devasting events that to one’s financial security, even for those who are high earners. Typically left with only 50 percent of the accumulated net worth, and possibly having support obligations, it is difficult to rebuild the assets that are no longer on the personal balance sheet.
However, by understanding certain fundamental strategies to wealth building, high earners can shift the focus from just earning income to rebuilding the nest egg.
One of the important concepts is to understand taxes. This is a key expense for high earners and while the paycheck completes replete with multiple taxes deducted for federal and state government and programs, there is an important consideration which is one’s marginal tax rate. With a focus on staying within the current bracket when selling appreciated assets, it will help mitigate extra funds that could be diverted to taxes unnecessarily and lower adjusted gross income or AGI, thereby lowering the taxes due.
With the sale of appreciated shares, capital gains taxes are applied either at 15% or 20% of the gains that are realized. Capital gains vary depending on the length of time the asset is held, as well as the income and filing status. If held for one year or less, they are classified as short-term capital gains and are taxed at the ordinary income rate. Assets held for longer than a year are subject to long-term capital gains and are taxed at 15 percent or 20% depending upon the filing status and amount of total taxable income.
Taking short term capital losses may be beneficial when any unused losses applied to short-term gains can be used to offset taxes on long-term capital gains. Tax efficiency in selling certain assets at a loss or gain can be instrumental in building wealth and key to minimizing taxes overall.
Where the high income earner places any income remaining for investment is important. There are three general classifications of investment accounts: tax-deferred, tax-advantaged and taxable accounts. Tax deferred accounts include traditional 401(k) or 403(b) accounts and traditional IRAs or SEP accounts. They not only provide a tax deduction against current income today, but grow tax-deferred, and then are taxed as ordinary income in retirement taken withdrawn either voluntarily or t meet required minimum distribution requirements.
Another vehicle is the Roth IRA which can be a substantial benefit to high earners. Even if one’s income does not allow for contributing to a Roth, a contribution may be made to a traditional IRA and immediately converted to a Roth IRA in the same year. The only taxes due would be on the earnings in dividends, interest or appreciation from the time of contribution until conversion which is typically nominal.
This is called a back door IRA and high income earners can utilize this tool to rebuild their wealth tax efficiently. Contributions grow tax-free, growth is tax-free, and withdrawals are tax-free. Furthermore, you are not required to take distributions from a Roth IRA as you are with a traditional IRA, which is a compelling reason to consider back door Roths. Another tax benefit is that withdrawals from the Roth account are not subject to Net Investment Income Tax when withdrawn such as RMDs and other withdrawals are from traditional 401(k) and IRAs. Depending upon the income in retirement, NIIT can be avoided. Finally, tax-free money is left to heirs with a Roth IRA so the high earner can enjoy legacy and estate planning benefits as well.
These accounts are intended to build long-term wealth for retirement. Additionally, brokerage accounts may supplement these savings and help rebuild liquidity for more near term goals such as paying for children’s educational expenses, family weddings, and home improvements. However, dividends and interest earned in brokerage accounts are taxed as earned, therefore care should be taken in what type of assets reside in brokerage accounts (lower income producing and greater capital gains) versus retirement (tax-deferred and income producing) accounts. A conscientious effort to diversity the tax structure of a portfolio with a dedicated savings target can improve a financial plan and rebuild wealth dramatically.
Contributions to wealth accumulation should be viewed relative to current income and desired spending levels. Contributions to a 401(k) of the maximum annually (without employer match) of $20,500 with $600,000 in earnings represents savings as a percentage of income of only 3.5 percent. This level of savings relative to income (and therefore probable level of expenses) will not support consistent spending levels in retirement. Thus, maximizing personal contributions to employer retirement accounts is a worth goal, but will not necessarily result in sufficient savings for high-earning professionals.
Knowledge that having significant levels of cash is insufficient to build wealth because of the effects of inflation, will redirect the mindset of the post-divorce high earner to determine an appropriate financial plan to invest. While market volatility can be painful to experience, regular monthly contributions in a tax efficient manner to retirement and/or brokerage accounts will allow for dollar cost averaging thus, lowering the cost. If purchased in a down market, those lots will rebound when the market recovers and the return will be amplified.
Conscious decisions in the post-divorce years can lead to drastically improved financial results over time.
Note: This article is for informational purposes only and is not intended to provide either tax or legal advice. Please contact your attorney or accountant and rely on their independent research and advice for these matters.
