You’ve heard the old jokes “When is a door not a door?” … “When it’s ajar.” or “When is a car not a car?”… “When it turns into a driveway?” Well, I’ve got a new one for you: “When is $100,000 not $100,000?” The answer? “When it turns into a marital asset to be divided in a divorce settlement.”
Okay, it’s not quite as pithy, but you get the idea…
If you’re contemplating divorce—or in the midst of one—and trying to make prudent decisions about how to split the assets you and your spouse have accumulated during your marriage, here is something to keep in mind. Let me give you the hypothetical example of Dick and Jane, who are ending their 15-year marriage.
First, they sat down at the kitchen table and made a list of all of their assets, and it looked something like this:
- Dick’s 401(k) = $100,000
- Joint E-Trade brokerage account containing stocks = $100,000
- Vacation condo – worth $650,000 – $550,000 mortgage = $100,000 equity
- Joint checking account – $25,000
- Joint-owned CD – $15,000
For this discussion, let’s focus on the first three items. To a logical person, it would make sense that the 401(k), the brokerage account and the vacation home all have the same value. But let’s take a closer look.
Dick has accumulated his 401(k) account balance during the past 15 years at his company while Jane decided to give up her writing career (or at least suspend it) to be a stay-at-home mom to their ten-year-old son and 13-year-old daughter. Because of the nature of the account, no taxes were paid on the money going into it, while the value appreciated tax-deferred every year. When it is withdrawn during retirement, all amounts will be taxed as if it were ordinary income.
In addition to Dick’s retirement savings, the couple has also accumulated $100,000 in a brokerage account that was used to purchase several blue chip stocks for long-term growth. The money that was put into that account was fully taxed when Dick received it in his paycheck, and only the amount earned on that money—when the stocks are sold—will be taxed at the capital gains tax rate.
Lastly, seven years ago they purchased a vacation condominium in Hilton Head (after the real estate crash) for $560,000, and it is now worth $650,000.
Are each of these assets—seemingly worth $100,000—really worth that much in a divorce when Dick and Jane must achieve an equitable distribution? Maybe not. Let’s compare:
For comparison purposes, let’s look at the value of the 401(k) as it stands now and assume the full amount could be withdrawn today with no penalties. With a 25 percent tax bracket, that means the after-tax value of the account is $83,458.
Likewise, if Jane wanted to withdraw the full value of the brokerage account, she would sell all of the stocks owned in it, and pay taxes on only the appreciated amount—RATHER THAN on any of the original principal that was originally put into the account. So assume the total account has appreciated 30 percent since the stocks were purchased. That means Jane will pay a 15 percent long-term capital gains tax on $30,000, which equals $4,500. Therefore, the after-tax value of the account is $95,500.
Now, compare the vacation house—which has appreciated in value by $90,000. If Jane decides to sell it, she would pay capital gains tax on the $90,000 minus her selling expenses. If she doesn’t sell the house, then she needs to consider the expenses associated with maintaining it.
In summary, you have:
- 401(k) = $83,458
- Brokerage account = $95,500
- Vacation home = less than $76,500 (depending on selling expenses) if sold; $100,000 (plus expenses) if kept
These are simplified examples, but you start to see how the face value of a marital asset can change drastically once you consider (a) the type of asset it is, (b) how it is taxed, and (c) how much it costs to maintain. If Jane plans to keep—rather than cash out—whichever investment account she gets in the divorce, it would make sense to also compare the attractiveness of tax-deferred growth inside the 401(k)—or rollover IRA as it will become if Jane gets it in the settlement—for many years to come versus the brokerage account in which dividends and earnings on liquidated investments are taxed annually but the principal has already been taxed. It can get even more complicated when you consider the impact of inflation, factor in investment returns and account for transaction costs. But all of these must be considered to reach an equitable property settlement.
According to the Institute for Divorce Financial Analysts, assuming that retirement assets have the same value as an equal dollar amount of non-retirement assets is one of the most common mistakes made by divorcing couples. It pays to take the time—just like Jane did—to consult with a divorce financial expert to make sure that you are properly considering all aspects of your settlement.