Pitfalls Associated with Attempts to Tax Impact Retirement Assets for Equitable Distribution
It has become common practice in equitable distribution calculations to reduce pension and other tax-deferred retirement asset valuations in an attempt to adjust for the fact that these assets consist largely, if not exclusively, of pretax dollars. However, there are several problems associated with this practice, and they should be considered by divorcing parties and their advisers.
A Common Scenario
An attorney represents the wife in a divorce case. She wishes to be sole owner of the marital home after divorce. Her husband would like to keep his retirement savings, which have been valued at approximately 150% of the value of the house. He has offered to exchange his ownership interest in the house for her 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 net this adjustment for taxes would be roughly equivalent to the value of the house. There are no unrealized capital gains taxes associated with the house. Is this a fair deal for your client?
How about the following scenario? In this one, the parties wish to make the same exchange, and the valuations and other pertinent financial details are also the same. As above, the husband indicates he would like his wife to give him an immediate credit offset for the unpaid taxes. The calculated current value of his pension, as above, is based on his retirement at age 65, the earliest normal retirement age at his company. According to the parameters used in these valuations, he will not begin collecting and paying taxes on his pension for a period of about 16 years. For purposes of this example, he plans to draw on his other retirement assets in exactly the same fashion. Based on a life expectancy of approximately 34 years, he would stretch payment of taxes on these distributions over the ensuing 18 years.
This deal is exactly the same as the one above, but it is stated in different terms. Is this a good financial deal? Not if you are the wife! And here is why!
Because of the time value of money, the husband will be paying taxes with less valuable dollars. Delaying payment will also give him the opportunity to take advantage of tax-deferred compounding — the longer the delay, the greater the benefit. Because of tax-deferred growth, he will more quickly accumulate money in these accounts, which in turn will generate substantially more income in retirement. These two benefits, over the above period of time, will vastly exceed the cost of any unpaid taxes.
Furthermore, in contrast to her husband, the wife will be giving away upfront the value and growth potential of this credit offset. Assuming the rate of growth of the traded assets is equivalent, the current value of the retirement assets is 50% greater than the house, and it will therefore grow 50% faster.
What the Pension Valuators Say
New York Domestic Relations Law states that “the tax consequences to each party” should be taken into consideration in equitable distribution determinations. Unless such distributions are subject to immediate payment, this calculation is extremely difficult, if not impossible, to do with any precision.
As stated in pension valuations prepared by Lexington Pension Consultants, Inc., “In most cases, pensions are not in collection status and it would be pure speculation to tax-impact future distributions. Additionally, numerous factors such as additional employment after retirement, distributions from IRAs, and marital status affect an individual’s tax status. Therefore, unless otherwise noted, the pension values provided herein are pre-tax figures.”
Tax Impacting Future Distributions Is Speculative
Is it “pure speculation to tax-impact future distributions?” A quick review of historical changes in tax rates provides some insight into this question. Since 1980, there have been eight changes in the top Federal marginal tax rates for individuals, ranging from a high of 70% to a low of 28%. Six of these changes have been reductions; two have been increases. The current top marginal tax rate is 35%. A potential major overhaul of the tax code will likely be considered in the near future.
While this history of variability in marginal tax rates is compelling, it is also an oversimplification and does not take into account other tax changes that have taken place — changes for example in the rates at which investment income including capital gains is taxed, changes in the Alternative Minimum Tax, income-based phase-outs in the deductibility of itemized deductions and personal exemptions, changes in the taxation of Social Security benefits and changes in the tax treatment of the marital residence. Given this history, it would not be surprising if tax changes associated with the marital home were also included in a future overhaul of the current tax code.
As alluded to in the above quotation from Lexington Pension Consultants, even if future tax rates could be accurately predicted, a retiree’s future taxable income would still be dependent upon various contingencies, and it is therefore also speculative.
Taxable Income, Marginal Tax Rates and AMT
In the above 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 that amount.
A common error associated with using marginal tax rates in 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 the above 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. As a result, they are also keys to many of the problems associated with attempting to adjust these valuations for taxes.
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 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.
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 investment 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.
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 the above 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.
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.