Ask the Advisor: What you Need to know About Divorce and Money
I recently received a question from someone who wishes to remain anonymous: he and his wife are considering separating and he was wondering about his next step financially – specifically about relocating and what his options are.
Divorce is an unsettling time and one of the biggest concerns is where to live. And this is a question I have had often from recently divorced people:
Should they use their portion of retirement accounts to buy a new house?
If a large part of your divorce settlement comes in the form your former spouse’s retirement accounts, it can be tempting to use that money for a down payment on a new house. Here is why I discourage this idea:
You will take an enormous tax hit: Say you want to use $50,000 out of a 401(k) plan to buy a house. You will be adding $50,000 to your annual income for the year (in addition to work and/or maintenance payments) for tax purposes. If you are under age 59 ½, you also will be hit with a 10% early withdrawal penalty.
If you are in the 25% tax bracket, that $50,000 withdrawal will cost an additional $12,500 in taxes plus $5,000 for the IRS penalty. So, that $50,000 down payment actually costs you $67,500 after you pay the IRS.
You sacrifice your future retirement: Using the example of the $50,000 withdrawal, let’s figure out what you will give up in retirement security by using that money for a house. Say you are 45 years old and will retire at age 65. If you average 7%/year growth in a stock mutual fund over 20 years, that $50,000 would be worth $179,000 at retirement.
You may not know where you want to permanently settle right after your divorce: My realtor friends tell me that buyers shouldn’t expect to make money on a home purchase if they are in the home for less than 5 years. Commissions, moving expenses, and uncertain real estate values make a home purchase a long term investment.
Since divorce is a time of adjustment, it’s hard to say where you will want to live 1, 2 or 3 years after the split. Maybe a new job will require relocation. There may be child custody arrangements that necessitate a move. It may make sense to take 6 months or so to rent and see what happens in your life before you commit to a new real estate purchase.
Although you are likely feeling unmoored after a divorce, don’t let emotions cloud your smart financial judgement. Taking money out of a retirement account to buy a house was a bad idea when you were married and that doesn’t change after a divorce.