Avoiding Missteps on the Marital Balance Sheet
In divorce cases, it is important to develop the marital balance sheet to ensure that marital assets and liabilities are accurately valued and equitably (equally in community property states) divided. The marital balance sheet is a valuable tool for shaping well-formed property division decisions.
Three of the most common mistakes that occur when a Certified Divorce Financial Analyst® professional is not involved include:
1. Incorrect Allocation of Separate Property Interest in Real Estate
If the source of the down payment was one party’s separate property, that is, funds acquired and traceable to before the date of marriage, in California and many states, this down payment remains the property of that party. If the party is making a claim for separate interest, it should be deducted from the proceeds along with the payoff of the mortgage loan if applicable.
2. Treating Pre-Tax and After-Tax Retirement Accounts Equally
While all of the retirement accounts and pensions typically are categorized in a separate section of the marital balance sheet, care should be taken to ensure that the Roth IRAs are distinguished from the Traditional IRA and 401(k)/403(b) accounts.
Roth IRAs are contributed to “after-tax” and are not subject to taxation upon withdrawal. This is not true for Traditional IRAs, SEPs, and qualified accounts such as the employer 401(k)/403(b) accounts. These are taxed at ordinary income tax rates when withdrawals are made because their contributions were from pre-tax money and a deduction was take on taxes at the time of the contribution.
Another distinction is that non-Roth IRAs are also subject to required minimum distributions and cannot be withdrawn before age 59.5 without penalty (with some exceptions). The exceptions include first-time home purchase, college expenses, birth or adoption expenses or the Rule of 55 for traditional IRAs and Rule of 72(t) for qualified accounts (401(k), 403(b)) which have complexities and penalties associated with the withdrawals if not executed perfectly.
Roth IRA accounts are not subject to required minimum distributions nor are there any penalties or taxes applicable if withdrawn after age 59.5 and if held for at least 5 years.
Another exception is withdrawals pursuant to divorce. There is an exception for any penalties being applied to qualified plans (401(k) and the like) if taken at the time of division pursuant to divorce. The recipient spouse who is a non-employee is called an “alternate payee” and is allowed to withdraw money from the account without penalty, but still subject to ordinary tax rates on the contributions, earnings and appreciation. The withdrawal does not have to be in installments and may be a lump sum.
3. Failing to Delineate Unrealized Gains and Losses within a Brokerage Account
While the value of brokerage accounts may appear to be equal, further analysis should be conducted regarding the unrealized capital gains that the various positions retain.
The after-tax effect of applying a capital gains tax and possible net investment income tax on these gains could significantly impact the equalized valuation of accounts. If the parties are not dividing the positions by “units” and dividing instead by valuation, the net values for each position considering the capital gains inherent in each position is essential for an equitable division of assets.
This is of concern especially for those securities and assets that have low cost basis associated with them. Cash, equities, bonds, mutual funds, ETFs, and other types of securities are best divided by the units so that each party equally shares in the unrealized capital gains for each position.
4. Failing to tax-affect RSUs, ISOs, NQSOs, and other Deferred Compensation
Many couples do not want to continue to be tethered to each other post-divorce if they can mutually avoid it. Deferred compensation which inherently has some marital component but is not vested or realized until after the final decree of divorce causes issues with being further “tethered.”
Oftentimes, the solution is to offset the amount with another asset. While restricted stock options (RSUs), incentive stock options (ISOs), and non qualified stock options (NQSOs) all can be handled during the divorce in such a manner, it is not always in the best interest of the non-employee party. The market conditions may undervalue the potential in the community property interest of the assets and there are other reasons not to pursue this option. Of course, one advantage to handling the unvested amounts during the divorce proceedings is that it may be uncertain that the unvested portions may ever be realized because of layoffs or termination of the employee spouse. But if security is not a cause for concern, the assets may be better handled by a constructive trust in the Marital Settlement Agreement.
The impact of having to divide community property that vests at a later date is that the employee will be affected with the taxes on both his/her portion of the community property options/units AND on the ex-spouse’s portion at the time of vesting or exercising. The tax affect of these transactions needs to be handled via reduction in the units/shares/options to cover the cost ofo the taxes (and not just the typical 22% federal amount withheld at the time of vesting by the employer as a default) but also the amount that is in effect actually paid to the IRS and state when taxes are filed. This is often much larger because of the state taxes as well as the consideration that the employee is likely in a higher marginal tax bracket than 22%. Furthermore, there may be Net Investment Income Tax assessed on these transactions and additional Medicare tax for anyone earning over $200,000 annually.
Avoid the mistake of taking the deferred compensation amount at face value. There is a tax effect that needs to be considered when dividing these assets on the Marital Balance Sheet. This article does NOT constitute legal advice and is for general information purposes ONLY. Prior to making any decisions, seek legal counsel from a licensed attorney.
