As part of all California divorces, there needs to be a division of assets and debts. Each asset and debt should be fairly valued. A factor that is sometimes overlooked in certain assets is embedded taxation (and possibly other costs) which affect their real value.
Many types of assets do not have embedded taxation or other costs. Examples are bank accounts and physical assets such as cars and furniture. If a choice is made to liquidate them, no tax needs to be paid. And normally any selling costs would be minor or zero.
But other types of assets normally do have embedded taxation and/or “hidden” costs associated with them. These include:
- Real estate
- Brokerage / investment accounts
- Pre-tax retirement accounts such as 401ks and traditional IRAs
- Normally tax-free Roth retirement accounts (if there is a plan to liquidate all or part of them in such a way as to trigger taxation or penalties)
Analysis of Embedded Taxation
Therefore, in the interest of fairness and to obtain an understanding of actual value for these assets, an analysis of embedded taxation and other hidden costs should be undertaken.
If it is not done, an example proposed 50/50 split might have one spouse receiving a $50k bank account and the other spouse receiving a traditional IRA with a face value of $50k. On the surface they are equal.
However, the monies in the $50k bank account can be spent without triggering any taxation. But a withdrawal of monies in the traditional IRA would cause the amount withdrawn to be treated as income in the year of the withdrawal. And there may be a penalty for the withdrawal if the withdrawer has not yet reached the age at which there is no such penalty.
So it might seem that it’s better to receive the $50k bank account than to receive the $50k traditional IRA. But not necessarily so. Money in the retirement account can grow without any taxation until withdrawal(s) begin. But if the money in the bank account is invested in a brokerage / investment account, taxation of the resulting dividends and capital gains can occur each year.
Time Horizon
So if your time horizon for needing the $50k is short, the bank account is more advantageous. But if it is long, the traditional IRA is more advantageous.
How should we define “short?” There is no legal definition, but if there is a plan to liquidate all or part of an asset in the near future, the embedded taxation and any other hidden costs should be taken into account.
For example, if a house is going to be sold as part of (or soon after) a divorce, the selling costs and any capital gains tax that will have to be paid will reduce the net proceeds from the sale. Therefore, it would make little sense to ignore these when establishing a value for the house for the purposes of negotiating an overall asset/debt split.
What is a “long” time horizon? Again, there is no legal definition.
But, for example, what if there is no plan to start making withdrawals from a retirement account until say 15 years down the road when the spouse owning the account has retired? Normally the embedded taxation would be ignored. This is because:
a) the account has had the benefit of growing tax-free for the 15 years;
b) the spouse’s total annual income will probably be less than today (because of retirement) and therefore the spouse will likely experience lower tax rates than currently;
c) the time value of money – which says that the value of say $50k received 15 years from now is worth less than the $50k would be today; and
d) there is considerable uncertainty as to what will occur over the next 15 years in terms of the market value of investments and taxation policy, among other things.
Getting Help
So, as you can see, whether to take into account embedded taxation is rather complex and depends to a large extent on how long the asset will be held. This may or may not be known at the time of the divorce.
A Certified Divorce Financial Analyst can help you analyze this. And ultimately, it is a matter for consideration and negotiation in the divorce conversations, preferably with the assistance of a skilled and financially-savvy divorce mediator.
