Post Divorce Recovery Strategies:
Divorced Dads Financial Survival Guide
If we were to run a competition for divorced Dads, with the winner being the one who made the most financial mistakes during divorce, the field would be enormous and the stakes are high. It’s sad, but true.
Most Dads make mistake after mistake with financial settlements and they need help. This article is written specifically for divorced Dads and the many challenges they face in their post-divorce recovery (don’t worry, we’ll return to cover the specific and very different issues facing divorced Mums in a future article).
Regrettably, I can’t patch up the differences that contributed to the end of your marriage but what I can do is make sure that both parents are afforded every opportunity to recover to their best possible outcome financially.
There are a significant number of strategies you can use which will marginalise the downside, make your recovery as fast as possible and ensure that you can continue to provide for your children in the best possible way. The strategies I cover in the following pages are widely applicable, but ideally targets divorced Dads who:
- Are left with 25-40% of assets.
- Have dependent children.
- Have limited custody of their children.
- Have a higher income (than the Mum).
- Paying child maintenances.
- Renting or with a big mortgage.
Let’s look at a common scenario for a typical ‘Divorced Dad’:
Sadly, a marriage ends. The Mum receives say 65% of the asset base which normally includes the tax free family home. The father typically receives a cash settlement or other assets such as a rental property, shares or his superannuation that may have once formed part of the marriage pool.
The settlement he has earns interest, dividends or rent upon which tax is payable which also increases his income for (post-tax) child maintenance payments (makes them higher).
In an attempt to start again, Dad will usually buy a house to live in. Typically, house prices have increased during the protracted separation process, the deposit saved for the purchase comes from after tax income, and he is also up for stamp duty and all the associated costs of buying a residence.
Dad is really stretched financially. He is facing new mortgage payments which he has to work harder to meet, paying more taxes on his extra income, making greater child and possibly spouse maintenance payments (made higher the more he earns) and paying for a whole new suite of costs associated with living separately. He is now in a viscous circle from which he will struggle to escape.
Divorce lawyers in my mind aren’t acting fully in the best interest of their clients if they aren’t across the intricacies of the tax / financial system; usually it’s not their area of expertise e.g. try explaining to a Dad that whilst the rental property was transferred to him tax free at settlement when he sells it the tax liability didn’t go away it was only deferred and he’ll pay it all.
Any divorce lawyer who doesn’t instruct his client to seek separate tax / financial advice before accepting a settlement and to have a plan for post-settlement recovery should be racked with the guilt of a significant omission in service. Most importantly for them Dads simply cope and accept much better with what they perceive as their ’lousy’ settlement if they have a financial plan for going forward again – makes a divorce lawyers job easier.
How to move on
Invariably at this point you have so much to process emotionally, spiritually and practically. Singularly, the most productive and empowering approach a Dad can take at this juncture is to start the process of recovery.
The best way to move on financially is to latch on to a strategy that you believe in and can commit to. You’re not alone and there are many avenues for support and guidance. Make an appointment to see someone like myself, get some direction and get going. There are always ways forward.
There are two “suggested” roads to recovery in this short article (there are many others).
- If you are aged less than fifty, look to buying a home, building equity again.
- If you are over fifty, look to SAFE superannuation while renting or pay interest only on a home.
In both cases we also consider a raft of other tax effective investing strategies regardless of your age or circumstances, but these are covered in my other books.
What is the primary objective from here?
- To structure a protected wealth recovery strategy by using all available tax allowances, concessions and deductions.
- To accelerate the funding of the recovery program through the leveraging (when appropriate) all permissible tax allowances, concessions and deductions.
Get a roof over your head
When marriages break down for whatever reason and there are children involved, usually the Dad moves out. As a result, the departing spouse faces significant costs to establish a new home.
As in our case study they begin to pay child maintenance and, in some cases, spouse maintenance. It is only after these payments that they can then fund their own costs of independent living including rent, electricity, water, gas, etc. But here is my point – it’s all in after tax dollars. In this respect, the taxation system is really working against you.
As we read, the inevitable asset split usually favours the child-rearing parent (and rightfully so) and the asset growth that the child-rearing parent enjoys is usually tax free given that it’s most likely to be the family home. In most cases, the Dad is left with a smaller capital base (which appreciates at a proportionally lower amount), and, even then, any increase on that smaller capital base is taxed.
The good news is that there are lateral ways to address this asset and tax imbalance. Superannuation is one very powerful avenue as it is taxed on a concessional basis (15%) with the implication being that when you reach the age of sixty (and retire) the proceeds to you are totally tax-free.
In all cases, building equity is important.
Banks love equity and will readily lend against it, affording you wealth-building opportunities along the way. Buying a home is important, but paying for a home in after tax dollars post age fifty is not the optimal approach. As compelling as it may seem, you would have a hard time convincing me of its merits when there are much better options available.
Let’s look at some examples to illustrate the points.
Buy a home and rent it out (rather than living in it). Keep your own rent costs low or even consider sharing a place with family, friends or a colleague.
By doing this you expose yourself to capital growth which gets you back in the game. Any capital gain here will, unfortunately, be taxed upon sale (so don’t sell!) This is perfectly fine, because you will use that (unrealised) capital gain to leverage off into your next opportunity.
Alternatively, consider this approach via one of the superannuation investment strategies (described next) and avoid all tax on the sale in retirement. Very powerful stuff!
Here’s how it works:
$400,000 House/Unit loan
$28,000 Interest payable at 7%
$2,500 Rates, repairs, body corporate, etc
($19,500) Rent received
$11,000 Cash flow loss
$1,500 Non cash – Chattel depreciation
$7,500 Non cash – Building depreciation at 2.5%
$20,000 Tax loss
$6300 Tax refund at 31.5%
$4700 Cash flow loss
*A reminder: in this example we have used a tax rate of 31.5%. (The tax saving rises to $9,300 for a tax payer on the 2012 top tax bracket – to a very low $1700 cash flow loss)
Not a bad scenario is it? Minor cash flow losses at worst and if you consider even a conservative capital growth rate of 5%, this equates to $20,000 per annum compounding on your $400,000 property. Over time you are going ahead, rents will increase, debts will be slowly repaid and the gap between $20,000 growth and net expenses grows and so does your ability to invest again.
Where to from here? Buy another property as your equity grows over time, diversify into higher yielding shares (my preference) or buy a property with your superannuation funds. It is all very achievable. The main outtake is ‘Do something, don’t do nothing’.
Words of warning – Always allow for affordability in your strategy. For example, if interest rates move to higher levels, so too will your loan repayments.
Fortunately, if interest rates rise, so too does inflation and rents (usually) with it, unless things get really ugly of course, then were all in trouble but at least interest rates will be very low! As a rule of thumb, allow for 2- 3% above current rates and for periods of vacancy, major repairs etc.
The key is to keep your living costs down, and that may be best achieved by actually buying a house however if you are over fifty, I strongly recommend that you consider interest-only payments and salary sacrificing the extra amount into a SAFE superannuation option, then paying out the balance of the loan tax-free at aged sixty-plus retirement.
The passage of time should inflate the property’s value. At the age of forty you have a probable twenty-five years left in the work force – plenty of time to reap the rewards of a longer term approach.
Before we lose you at this point (as the performance of managed superannuation has been abysmal of late) and as there is a strong reluctance towards super ‘hear me out’ as we discuss later in this section the do-it-yourself super options and the super tax concessions that just cannot be ignored.
Tax-effective investment doesn’t get any better than making pre-tax contributions to superannuation. Super contributions are taxed at a low 15%. Compare this to the 31.5% tax rate most taxpayers face, meaning that for every $100 you ‘salary sacrifice’ into superannuation, you have an immediate saving of $16.50* in tax.,/p>
*A reminder: in this example we have used a tax rate of 31.5%. The tax saving rises to $31.50 for a tax payer on the 2012 top tax bracket.
Simply by putting money into superannuation you have made a 16.5% return on your pre-tax money (or just made 3+ years of term deposit interest on it) or a 31.5% return on your pre tax money if you’re a top taxpayer (you can figure out how many years of term deposit interest that one is) so don’t discount using SAFE super for post divorce recovery.
Assume you pay tax at the 31.5% tax rate and receive a $10,000 bonus. You would ordinarily lose $3,150 in tax. Alternatively, if you declare to have your bonuses paid directly into superannuation, you lose only $1,500 in tax. That’s a big difference of $1,650 that you will keep. The ‘catch’, of course, is that you cannot get to this money until your old enough to be retired (55-60 depending on your age).
With superannuation, though, the tax-effective savings don’t stop at the contributions level as earnings derived from superannuation funds are taxed at just 10%-15%. After you have retired, it gets even better, as the earnings attract an unbelievable tax rate of zero!
Further, the tax paid on a superannuation payouts after the age of sixty (and retired) is again zero!
Earnings, too, in superannuation aren’t counted as income for child maintenance, something further for you to consider (if appropriate) and discuss with your advisor.
A general rule with contributions to superannuation is that before making additional salary sacrifice payments to superannuation, repay all your non-deductible loans (such as home loans, credit cards, etc) and other expenses prior to the age of fifty. Once beyond the glorious fifty – consolidate and hold debt and it’s all super, in nearly all cases.
As mentioned as a tax advisor, I see a lot of resistance from people when considering the idea of contributing more to superannuation. This is because many people don’t like managed superannuation funds (usually due to fee structures, poor performance in some cases, and the fees paid to financial planners). For these people, running a self-managed superannuation fund (SMSF) is often the right answer.
Sometimes it can be very difficult to show the tax benefits to someone who is resistant to superannuation to having their $200,000+ in the XYZ Managed Fund. In these cases, it is much easier to show the tax savings with an alternative: investing the $200,000+ in their own superannuation fun (an SMSF), which then buys a small factory (for example) and then rents it back to either the investor’s business or someone else’s. (same strategy for residential property, except you cannot rent it back to yourself or an associate).
SMSFs provide investors with the ability to make investment decisions for themselves. As of September 2007, borrowing funds inside your self-managed super is now a reality through the prudent use of easily constructed instalment warrants. An instalment warrant is a form of derivative, and I am well placed to advise on the benefits of using them in SMSFs. These are both something I am particularly passionate about – so passionate, in fact, that my doctoral thesis was about SMSF and levels of measurement for safe leveraged investment.
Put $200,000 into their own SMSF, which then borrows a further $200,000 through an instalment trust structure and buys a factory (or residential unit, of course not renting that one to yourself or an associate) renting the factory back to either the investor’s business or someone else’s – cash flow positive and your 9% super payroll contributions further help pay down the loan fast.
Your SMSF buys farming land and rents it back to you. You plant a tree plantation on it, claiming the tax deductions to do so – other tax deductions include annual expenses such as the rent you’re paying to your superannuation fund, insurance, plantation and financing costs – while your plantation grows till you reap the rewards of the “harvest” (do this one for myself).
As discussed earlier, your own superannuation fund can borrow through an instalment warrant to buy the land. It’s almost too good to be true, but it isn’t – it’s a tax-effective reality!
Divorce is one of the more unsavoury, unproductive and debilitating experiences that anyone can go through, and the financial hardship associated with divorce will be one of the greatest and enduring hurdles that any divorced Dad will face.
There are a significant number of strategies beyond those covered here that will substantially enhance the financial recovery of those affected. And this is fundamental to the overall well-being of the Dad and his ability to father his children as best he can.
It is all very achievable. Here’s a summary of what you need to do:
- Get advice first, and get it quickly (before your settlement).
- Get some equity going (housing or shares etc) prior to age 50 – simple enough!
- Maximise the super power of superannuation post age 50. Why? Because it’s yours, it’s protected, it has so many tax advantages and it will be instrumental in accelerating your wealth recovery.
Superannuation offers fantastic opportunities to recover from divorce:
a. Immediate tax-effective return on your contributions.
b. Concessional (low) tax rates on the earnings.
c. Tax free status at age sixty (and retired).
d. The ability to borrow through instalment warrants (enabling your SMSF to buy property).