By Carl Palatnik
Should Retirement Plans Be Discounted for Taxes?
Discounting retirement plans for taxes is a tricky business and can sometimes
lead to problematic or inequitable settlements. Although methodologies exist
for valuing such plans, these methodologies do not involve tax impacting —
and for good reason. The problem is twofold: 1) The true after-tax value of
retirement assets is context-driven and thus varies with the rate at which each
of the parties will be taxed when distributions are taken; and 2) Although often
ignored, these plans often involve tax-deferred compounding, which can dramatically
enhance their value over time.
Effect of Tax-Deferred Compounding
Figure 1 compares the effect of tax-deferred compounding at 9%, on $10,000,
with an after-tax value calculated using a combined Federal and state tax rate
of 35%. As shown, the difference between the tax-deferred and after-tax values
increases exponentially. By the 24th year, the tax-deferred value is more than
double the after-tax value. To illustrate the magnitude of this difference,
assuming that the owner begins drawing income only at the end of the 24th year,
the tax-deferred account generates $7120 annually versus $3522 from the after-tax
This example indicates that, although these assets have an equivalent initial
value, their future values diverge radically because of tax-deferred compounding.
With respect to both long-term growth and income potential, retirement assets
are clearly more valuable to the party with the longer time horizon.
Consequences of Discounting
Although the above example shows that the future value of tax-deferred assets
increases more rapidly than after-tax assets, and that this difference can be
especially significant over time, this fact is generally ignored in fashioning
settlements. Instead, a major focus has been on tax-impacting retirement assets
that are primarily or exclusively composed of pre-tax dollars. It is therefore
fairly common practice in situations where these assets will not be divided
equally for the parties to attempt to discount the retirement assets for taxes.
For example, suppose one of the parties receives $10,000 in retirement assets
and the other $6500 in after-tax assets (discounted 35% for taxes) (Figure 2).
Other than this assumption, the facts in this example are the same as those
outlined in Figure 1. Such discounting further accelerates the rate at which
these assets diverge. In such a case, it only takes about 9 years for the tax-deferred
asset to double the after-tax asset, compared with about 24 years in the example
shown in Figure 1. Further, by the 24th year, the after-tax asset will only
generate $2290 per year, less than one third the tax-deferred asset.
Effect of Financial Position
As previously stated, the respective value of retirement plan assets to each
of the parties is context-dependent. For instance, compare $10,000 in tax-deferred
assets with $6500 in after-tax assets (Figure 3). In such a case, the party
receiving the assets is in a significantly lower tax bracket (15%), is under
age 59 and thus subject to a 10% excise tax on retirement plan withdrawals,
and will need to withdraw $1000 at the end of each year. This example also assumes
that this party has the ability to access the retirement plan assets, for example
through an IRA rollover. This person’s low tax bracket, age and short-term
needs might suggest that $6500 in after-tax assets would be more valuable than
$10,000 in tax-deferred assets. However, the opposite is true. In some cases,
the $10,000 in tax-deferred assets lasts more than 5 years longer than the $6500
in after-tax assets. (Figure 4).
In fact, it will take about $8500 in after-tax assets to produce about the
same long-term results as $10,000 in tax-deferred assets.
Lump Sum Withdrawal
The above examples show that, given the opportunity for tax-deferred compounding,
it is frequently more advantageous for a party to receive retirement plan assets
than highly discounted after-tax assets. They do not take into account, however,
the possibility that these assets might have to be withdrawn prematurely. What
are the consequences of interrupting tax-deferred compounding with a lump sum
withdrawal? For example: compare $10,000 in retirement assets with $6500 in
after-tax assets and, as in earlier examples, assume a growth rate of 9% and
a tax rate of 35%. Further, assume that the lump sum withdrawal is subject to
a 10% excise tax, resulting in a total discount of 45% (Figure 4).
Withdrawing the retirement assets as a lump sum under these circumstances is
initially disadvantageous to the owner. By the sixth year, however, despite
the payment of both taxes and penalties, such withdrawal still results in a
larger overall amount. Further, as in the above examples, this differential
increases exponentially and would be even greater if no penalties were incurred.
When it comes to retirement plans, divorce is not a zero sum game. Although
this article does not deal with such contingencies as differences between different
types of retirement plans, effect of payout status, or non-tax-related factors,
it illustrates some of the difficulties and risks inherent in attempting to
tax-impact retirement plans and other tax-deferred assets outside the context
of a divorce. Although the present value of a retirement plan might be calculable
using standard methodologies, the real-life value of retirement assets is complex
and context-dependent and can vary greatly with the manner in which they are
Many factors need to be considered in order to determine the true value of these
assets in a particular settlement scenario. These include age, short- and long-term
real or potential needs, future earning capacity, projected tax bracket at the
time of withdrawal and current and future needs for liquidity and accessibility.
Without taking these factors into consideration, one of the parties could end
up with a substantial windfall and the other with serious financial difficulties.
Attempting to tax-impact these assets by application of a simple, out-of-context
formula can potentially do more harm than good.
The inherent difficulty in finding equitable solutions to the division of retirement
plans raises two important issues regarding how these assets should be handled
in a divorce. First, because tax impacting is highly context-dependent, and
because valuations will be dependent upon future contingencies, should tax impacting
be simply ignored? Second, can the problems inherent in the valuation process
be overridden by dividing these assets separately from other assets, for example
by dividing them equally between the spouses rather than trading them for other
assets? The answer to both of these questions is an emphatic “no,”
as both of these alternatives can also lead to significant inequities.
The only way to arrive at an equitable solution to the division of tax-deferred
assets is through a thorough analysis of the assets in the context of a specific
settlement scenario. The analyses described in this article assume an annualized
rate of return of 9%, the approximate historical average for a