Retirement Assets for Equitable Distribution

A common error associated with applying marginal tax rates to this calculation is that it equates Gross Income with Taxable Income. Under current law, a person's gross income is subject to various adjustments prior to the application of tax calculations. Examples of such adjustments include determinations of the extent of taxability of Social Security income, application of Standard or Itemized Deductions and calculation of the value of personal exemptions. Income net of these adjustments is “Taxable Income,” and it is “Taxable Income” to which tax calculations are applied.

The following case illustrates problems associated with equating Gross and Taxable Income. In this case, the wife proposed a 31.3% tax discount of the value of her pension and other retirement assets based on an estimated combined Federal and State marginal tax bracket of 31.3%. Factoring in the value of her personal exemption and applying the Standard Deduction to her projected income, her marginal tax bracket ' based on her Taxable, not her Gross Income ' was actually 25%. Furthermore, because of the progressive nature of the tax code, only a portion of her income would be taxed at her marginal tax rate. Her effective tax rate, which would have been even lower had she been able to itemize her deductions, turned out to be 16.86% ' approximately half the rate the wife had offered to apply.

To potentially complicate this calculation, had the Alternative Minimum Tax (AMT) (an alternative tax structure originally intended for high income taxpayers who had benefited perhaps too greatly from taking advantage of so-called tax loopholes) been applicable in this case, the effective tax rate would have been different (although still lower than 31.3%). Ironically, because of inflation and consequent “bracket creep,” the AMT has been affecting greater and greater numbers of middle income taxpayers, resulting in multiple adjustments and temporary fixes, another highly variable factor that makes the need to do this calculation quite common.

Other Problematic Issues

In our theoretical scenario, the valuation of the husband's pension, calculated using standard procedures, assumes the husband does not begin receiving distributions, and therefore paying taxes on them, for approximately 16 years. It further assumes that these distributions will be paid over an additional 18 years, for a total of approximately 34 years. The length of the accumulation period and the initiation and length of the payout period are keys to the pension valuation process. And, as a result, they are also keys to many of the problems associated with attempting to adjust these valuations for taxes.

And what about issues associated with the time value of money, tax-deferred compounding and opportunity costs?

The Time Value of Money

Continuing with our hypothetical scenario, the wife is being asked to pay her share of the husband's deferred taxes upfront, with today's dollars, despite the assumptions in the pension valuation that distributions will not begin for approximately 16 years (the husband's normal retirement age) and, once initiated, will be made periodically and gradually over an extended period of time (18 years). Adjusting for CPI-U (Bureau of Labor Statistics, Urban Consumer Price Index), the index associated with CPI adjustments in the recently passed no-fault legislation, the husband will effectively pay approximately half as much tax in today's dollars as the wife, if she pays upfront and he pays over this extended period of time.

Tax-Deferred Compounding

The husband's proposal does not take into account the benefits of tax-deferred compounding. The benefits of compounded growth coupled with tax deferral are significant and, absent withdrawals for previously unpaid taxes, the rate of growth, ultimate value and ability of these assets to produce future income will diverge rapidly and far exceed any costs associated with tax deferral. This is one of the major motivations, and the major benefit, associated with investing in IRAs and other
tax-deferred retirement vehicles.

Although the actual benefits of investing in tax-deferred retirement plans is dependent on both tax rates and investment performance, some reasonable projections include: 1) The added value of tax-deferred compounding will exceed the total cost of deferred taxes in approximately 6-8 years; 2) In 20-25 years, the increased rate of growth of tax-deferred assets will cause them to grow to approximately triple the value they would have achieved had they not be allowed to grow tax-deferred (this effectively also increases their income-producing capacity three-fold); and 3) The benefits of tax-deferred growth and its differential from the growth of alternative investments will expand exponentially if left for even longer periods of time, further enhancing its value.

Opportunity Cost

There is also an opportunity cost associated with giving the husband an upfront credit for deferred taxes. If the wife agrees to this credit offset, she leaves the marriage with fewer assets and, because of this, smaller growth potential than her husband. Since retirement assets are frequently one of the largest classes of assets divided in divorce, this offset could be significant. In our example, the husband's retirement assets are worth 150% of the value of the house. If both classes of assets grow at equivalent rates post-divorce (the rate of growth of these assets is irrespective of whether taxes might be due on them in the future), this differential continues to increase, causing even further divergence of their future values.

Summary

Although tax-impacting of tax-deferred retirement assets is frequently attempted in equitable distribution calculations, the methodology for doing this is flawed and the result unreliable because:

• Adjusting for future taxation of these assets is highly speculative, from both a personal income and a tax law perspective.
• The currently employed methodology does not take into account the time value of money, and results in inflated credits/debits.
• The methodology involves upfront credits/debits for tax payments projected to be paid later ' often many years later. This opportunity cost negatively and immediately impacts the spouse paying these costs.
• The methodology does not take into account the benefits of tax-deferred compounding. Over time, the benefits of tax-deferred compounding can vastly exceed the tax costs associated with pre-tax assets.
• Tax-deferred growth, plus the ability to generate higher income upon retirement, frequently makes tax-deferred retirement assets extremely beneficial to own.
• Because of the above issues, retirement assets in many situations are more, not less, valuable to own than the assets for which they are exchanged.

Unless in payout status, attempts to tax-impact tax-deferred assets does not correct for but magnifies this difference, potentially making exchanges of retirement assets for other assets more inequitable.

Carl M. Palatnik, CFP', a member of this newsletter's Board of Editors, is a Certified Divorce Financial Analyst' and a principal of the Center for Divorce and Finance, LLC, with offices in Long Island, New York City and Westchester County. He is founding president and executive vice president of the Association of Divorce Financial Planners, and President of DivorceInteractive.com, an Internet divorce portal. He can be reached at [email protected] or at 631-470-0331.

In Part One of this article, published last month, we were discussing a hypothetical divorcing couple. The husband would like to keep all of his retirement savings, which have been valued at about 150% of the value of the couple's home, which the wife would like to keep as her own. The husband has offered to exchange his ownership interest in the house for his wife's interest in his retirement savings. His retirement assets consist entirely of pre-tax dollars, and he would like to get a credit for the estimated cost of the unpaid taxes (his combined marginal tax bracket is 33 1/3%). The value of the retirement assets after the tax adjustment would be roughly the same as the value of the house. There are no unrealized capital gains taxes associated with the house.

Taxable Income, Marginal Tax Rates and AMT

In our hypothetical scenario, the husband's income put him in a 33 1/3% marginal tax bracket, and the assumption was made that the value of his retirement assets for equitable distribution calculations should be reduced by one-third.

A common error associated with applying marginal tax rates to this calculation is that it equates Gross Income with Taxable Income. Under current law, a person's gross income is subject to various adjustments prior to the application of tax calculations. Examples of such adjustments include determinations of the extent of taxability of Social Security income, application of Standard or Itemized Deductions and calculation of the value of personal exemptions. Income net of these adjustments is “Taxable Income,” and it is “Taxable Income” to which tax calculations are applied.

The following case illustrates problems associated with equating Gross and Taxable Income. In this case, the wife proposed a 31.3% tax discount of the value of her pension and other retirement assets based on an estimated combined Federal and State marginal tax bracket of 31.3%. Factoring in the value of her personal exemption and applying the Standard Deduction to her projected income, her marginal tax bracket ' based on her Taxable, not her Gross Income ' was actually 25%. Furthermore, because of the progressive nature of the tax code, only a portion of her income would be taxed at her marginal tax rate. Her effective tax rate, which would have been even lower had she been able to itemize her deductions, turned out to be 16.86% ' approximately half the rate the wife had offered to apply.

To potentially complicate this calculation, had the Alternative Minimum Tax (AMT) (an alternative tax structure originally intended for high income taxpayers who had benefited perhaps too greatly from taking advantage of so-called tax loopholes) been applicable in this case, the effective tax rate would have been different (although still lower than 31.3%). Ironically, because of inflation and consequent “bracket creep,” the AMT has been affecting greater and greater numbers of middle income taxpayers, resulting in multiple adjustments and temporary fixes, another highly variable factor that makes the need to do this calculation quite common.

Other Problematic Issues

In our theoretical scenario, the valuation of the husband's pension, calculated using standard procedures, assumes the husband does not begin receiving distributions, and therefore paying taxes on them, for approximately 16 years. It further assumes that these distributions will be paid over an additional 18 years, for a total of approximately 34 years. The length of the accumulation period and the initiation and length of the payout period are keys to the pension valuation process. And, as a result, they are also keys to many of the problems associated with attempting to adjust these valuations for taxes.

And what about issues associated with the time value of money, tax-deferred compounding and opportunity costs?

The Time Value of Money

Continuing with our hypothetical scenario, the wife is being asked to pay her share of the husband's deferred taxes upfront, with today's dollars, despite the assumptions in the pension valuation that distributions will not begin for approximately 16 years (the husband's normal retirement age) and, once initiated, will be made periodically and gradually over an extended period of time (18 years). Adjusting for CPI-U (Bureau of Labor Statistics, Urban Consumer Price Index), the index associated with CPI adjustments in the recently passed no-fault legislation, the husband will effectively pay approximately half as much tax in today's dollars as the wife, if she pays upfront and he pays over this extended period of time.

Tax-Deferred Compounding

The husband's proposal does not take into account the benefits of tax-deferred compounding. The benefits of compounded growth coupled with tax deferral are significant and, absent withdrawals for previously unpaid taxes, the rate of growth, ultimate value and ability of these assets to produce future income will diverge rapidly and far exceed any costs associated with tax deferral. This is one of the major motivations, and the major benefit, associated with investing in IRAs and other
tax-deferred retirement vehicles.

Although the actual benefits of investing in tax-deferred retirement plans is dependent on both tax rates and investment performance, some reasonable projections include: 1) The added value of tax-deferred compounding will exceed the total cost of deferred taxes in approximately 6-8 years; 2) In 20-25 years, the increased rate of growth of tax-deferred assets will cause them to grow to approximately triple the value they would have achieved had they not be allowed to grow tax-deferred (this effectively also increases their income-producing capacity three-fold); and 3) The benefits of tax-deferred growth and its differential from the growth of alternative investments will expand exponentially if left for even longer periods of time, further enhancing its value.

Opportunity Cost

There is also an opportunity cost associated with giving the husband an upfront credit for deferred taxes. If the wife agrees to this credit offset, she leaves the marriage with fewer assets and, because of this, smaller growth potential than her husband. Since retirement assets are frequently one of the largest classes of assets divided in divorce, this offset could be significant. In our example, the husband's retirement assets are worth 150% of the value of the house. If both classes of assets grow at equivalent rates post-divorce (the rate of growth of these assets is irrespective of whether taxes might be due on them in the future), this differential continues to increase, causing even further divergence of their future values.

Summary

Although tax-impacting of tax-deferred retirement assets is frequently attempted in equitable distribution calculations, the methodology for doing this is flawed and the result unreliable because:

• Adjusting for future taxation of these assets is highly speculative, from both a personal income and a tax law perspective.
• The currently employed methodology does not take into account the time value of money, and results in inflated credits/debits.
• The methodology involves upfront credits/debits for tax payments projected to be paid later ' often many years later. This opportunity cost negatively and immediately impacts the spouse paying these costs.
• The methodology does not take into account the benefits of tax-deferred compounding. Over time, the benefits of tax-deferred compounding can vastly exceed the tax costs associated with pre-tax assets.
• Tax-deferred growth, plus the ability to generate higher income upon retirement, frequently makes tax-deferred retirement assets extremely beneficial to own.
• Because of the above issues, retirement assets in many situations are more, not less, valuable to own than the assets for which they are exchanged.

Unless in payout status, attempts to tax-impact tax-deferred assets does not correct for but magnifies this difference, potentially making exchanges of retirement assets for other assets more inequitable.

Carl M. Palatnik, CFP', a member of this newsletter's Board of Editors, is a Certified Divorce Financial Analyst' and a principal of the Center for Divorce and Finance, LLC, with offices in Long Island, New York City and Westchester County. He is founding president and executive vice president of the Association of Divorce Financial Planners, and President of DivorceInteractive.com, an Internet divorce portal. He can be reached at [email protected] or at 631-470-0331.