How Should Retirement Assets be Valued in Divorce? (tax affected)

Many a highly trained family law attorney will “tax affect” retirement accounts by using the after tax value of a retirement account on a couple’s inventory of assets.  As a divorcing man or woman you need to know that this method of valuation is more of a negotiation tactic then economics.  Left unchecked, the spouse receiving more of the retirement accounts may benefit (possibly unfairly) in negotiations from the practice of “tax affecting” retirement accounts.

Here’s an example:

Bob is 40 years old and works full time.  Bob plans to divorce Jan, a 40 year old stay at home mom who plans to return to work.  Bob has a retirement plan at work and the couple has a joint investment account.  Each account has $100,000 worth of stocks and bonds.  The couple also has a $40,000 cash savings account.

Bob’s attorney recommended the following division of accounts:

For Bob:

Retirement Account ($100,000 IRA account, tax affected at 25%, Bob’s marginal tax rate) = $75,000

Cash savings account $32,500

Total  $107,500

For Jan:

Investment Account $100,000

Cash savings account $7,500

Total  $107,500

Does this look right to you?  Did they get a 50/50 split?  To me it looks like Bob is getting $25,000 more than Jan — $132,500 and Jan is getting $107,500.

Here’s why.  Bob is at least 20 years from withdrawing his retirement account.  Thus, his tax cost in today’s dollars is much smaller than the $25,000 tax discount taken to his $100,000 retirement account.    Furthermore if he were in the 15% bracket when he retires, the tax cost in today’s dollars drops even more.

Lastly, if Bob’s attorney “tax affected” the retirement account why didn’t he also do the same to the investment account.  Jan may be subject to capital gain taxes if the cost basis in the account is less that the current value. And that could be significant.

On the other hand Bob is getting an account that is much less liquid than Jan.  Bob can not use the retirement account for many years unless he pays taxes at his current rate in addition to a 10% penalty on the amount he withdraws.  Meanwhile Jan can sell stocks and use the cash immediately without penalty although she may be subject to taxes on any capital gain.  Further analysis is needed but Bob might ultimately deserve something more than Jan because he is giving up liquidity — but perhaps not as much as in the example above.

This is more complicated than it initially appears.  In order to properly “tax affect” each account or asset, the parties would need to know when each account will be withdrawn and used as cash, how much with be withdrawn at each date, future tax rates for each party and the rate to use to discount the tax expense back to today’s dollars.  Complex?  Involves a lot of assumptions a.k.a. guessing? You bet.

The takeaway from all this — you’ll have to negotiate!  The example above is Bob’s attorney’s version on how assets should be divided, not Jan’s.  The “fair” answer is likely somewhere in the middle.  An experienced financial analyst can help explain to your spouse, attorney, mediator or judge why an account should be (or shouldn’t be) tax affected or whether a lack of liquidity is meaningful enough to divide assets differently.

P.S. One way that may avoid tax re-valuation issues is to divide each account.  However, that has it’s own costs. Divorce Planning of Austin can provide options and help you make a case for which option is best based on your circumstances.

P.S.S. What about someone who divorces at 65?  In this case, a tax adjustment is justified but the amount depends on several. factors including how much with be withdrawn each year (based on expenses) and amount of other income. I did an analysis of someone who was 65, planned to withdraw $20,000 a year from his $500,000 IRA and only had $54,000 of social security and pension income.  Based on his actuarial life, the present value of tax payments was just under 8% (assuming a 5% discount rate). 

P.S.S.S  If we were talking about a 401K/IRA as compared with a checking account, this would be much more clear. What is difficult when there is a house involved is that this may have tax consequences as well. We would generally tax affect if the taxes are “immediate and specific”. In the case of the IRA/401K, there is no way to avoid taxes through inheritance or exemptions. For the house, there may be a way to avoid taxes. It is by no means a black and white issue.


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