In the division of assets and debts part of a divorce, it’s important to assign an accurate or at least reasonable value to each asset. When assigning values, some family law attorneys (and possibly mediators) will suggest “tax affecting” retirement accounts. This means they propose using a lesser after-tax value instead of the face value.
So a 401k with an account value of $100,000 might be considered to have a “tax-affect” value of only say $70,000. This is because say $30,000 in taxes and penalties would have to be paid if the 401k is cashed in. The implication is that it would be fair and balanced if one spouse gets the $100,00 401k and the other spouse gets a $70,000 bank account.
“Tax Affecting” Problems
This approach to valuation is more of a negotiation tactic than something based on sound economics. Here’s why. And unfortunately it is rather complicated.
“Tax affecting” assumes that the retirement account money is all going to be withdrawn now. However, this is rarely the case. Usually the money won’t be withdrawn for many years until the withdrawer retires.
If withdrawals are deferred until retirement, the spouse who gets the retirement account will have three big advantages over the spouse who gets the bank account:
- When they finally pay taxes on the withdrawals, they will be doing so with less valuable dollars. Dollars in the future will be less valuable than today’s dollars due to inflation. This is sometimes called the “time value of money.”
- It’s likely that the withdrawer’s annual income will be less at retirement than it is now. Therefore, the withdrawer will have a lower tax rate then than today. And, therefore, the dollar amount of taxes to be paid on the withdrawal will likely be less then than now.
- The opportunity to enjoy the great advantage of retirement accounts: tax-deferred compounding. The retirement account can keep growing year after year with no taxes to be paid until withdrawals finally begin. And the longer the compounding is allowed to occur, the greater the growth from the compounding.
These advantages, over a period of only a few years, will start to exceed the cost of the taxes that would have to be paid if the money is withdrawn now.
Appropriate “Tax Affecting”
If you wanted to properly “tax affect” a retirement account, you would need to know many things including:
- how much will be withdrawn in each future year;
- how much other taxable income the withdrawer will have in each year of withdrawal;
- future tax rates;
- any applicable future tax penalties; and
- an appropriate rate to use to discount the future tax liability back to today’s dollars.
If the expected withdrawals will be many years down the road, this would require a lot of assumptions / guesswork.
The take-away from all this? Tax-affecting retirement accounts is not appropriate unless the money is going to be withdrawn in the near future. If you know in which year(s) the money will be withdrawn in the near future, it’s not too difficult to calculate about how much of the withdrawal will have to be paid in taxes and possible penalties. A Certified Divorce Financial Analyst or tax professional could assist with this calculation.
Another take-away is that bank accounts and investment accounts have much different tax implications than retirement accounts. Sometimes a spouse in a divorce may have a strong preference to receiving one over the other. If so, and the other spouse agrees, this preference may be honored. Otherwise, if the couple wants to do a 50/50 division of their net worth, it may be prudent / fair to give each spouse about half of the retirement account assets and about half of the non-retirement account financial assets.