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 Typical Scenario

You represent 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.

Because of the time value of money, the husband will be paying these and future 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, your client 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. This deal is the same as the one described above, but it is stated in different terms. Is this a good financial deal? Not if you are the wife!

What the Pension Valuators Say

Domestic Relations Law ' 236(B)(5)(d)(11) 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 is being hotly debated by Congress.

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 phaseouts 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 is not surprising that tax changes associated with the marital home are also included in the above-referenced debate.

As alluded to in the 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 is therefore also speculative.

Taxation of Retirement Benefits in New York

To further complicate the accuracy and reliability of attempts to tax impact retirement benefits, the State of New York has legislation of its own regarding the taxation of such benefits. For Federal, State and municipal employees, this effect is dramatic. Retirement benefits for these employees are completely tax free. For non-government employees or taxpayers funding their own IRAs or similar plans, there exists a Pension and Annuity Exclusion that waives tax on the first $20,000 of annual retirement income after a person reaches age 59 '. In contrast, retirement income generated from a divorce-related asset transfer from a non-government plan is not excludable, nor are distributions received from an annuity purchased using personal funds and not associated with employment.

Next month, we will further discuss things to consider when tax-impacting retirement benefits in equitable distribution, including taxable income, marginal tax rates and the alternative minimum tax (AMT).

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.

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 Typical Scenario

You represent 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.

Because of the time value of money, the husband will be paying these and future 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, your client 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. This deal is the same as the one described above, but it is stated in different terms. Is this a good financial deal? Not if you are the wife!

What the Pension Valuators Say

Domestic Relations Law ' 236(B)(5)(d)(11) 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 is being hotly debated by Congress.

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 phaseouts 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 is not surprising that tax changes associated with the marital home are also included in the above-referenced debate.

As alluded to in the 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 is therefore also speculative.

Taxation of Retirement Benefits in New York

To further complicate the accuracy and reliability of attempts to tax impact retirement benefits, the State of New York has legislation of its own regarding the taxation of such benefits. For Federal, State and municipal employees, this effect is dramatic. Retirement benefits for these employees are completely tax free. For non-government employees or taxpayers funding their own IRAs or similar plans, there exists a Pension and Annuity Exclusion that waives tax on the first $20,000 of annual retirement income after a person reaches age 59 '. In contrast, retirement income generated from a divorce-related asset transfer from a non-government plan is not excludable, nor are distributions received from an annuity purchased using personal funds and not associated with employment.

Next month, we will further discuss things to consider when tax-impacting retirement benefits in equitable distribution, including taxable income, marginal tax rates and the alternative minimum tax (AMT).

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.