“Tax discounting” is a (relatively) simple but important concept that frequently comes up in the divorce context. Although the concept itself is fairly straightforward, as with many things, the details can be pretty complicated. This article is designed to give you a general overview of the topic of tax discounting. Your mediator, attorney or CPA will be familiar with these concepts, so don’t feel like you have to remember all of this! This article is provided as general introduction to this topic and should not be construed as tax advice. You are encouraged to discuss tax discounting further with your CPA or tax professional if it may be relevant to your situation.
Tax discounting refers to reducing the value of an asset by the anticipated tax liability associated with the asset. Think of it this way: If you had to pay a $1,000 bill tomorrow, would you rather have $1,000 in cash or $1,000 in your 401(k)? The (likely) answer is that you’d would rather have the cash. This is because if you had to cash in $1,000 from your 401(k), you would not receive $1,000 – you would receive much less after taxes. (There would also be a 10% penalty if you were not 59.5 years old, but that typically does not get factored in.)
When it Matters: Equalizing Pre-Tax with Post-Tax Assets. If you are trading pre-tax assets (401k’s, IRA’s, etc.) for post-tax assets (cash, Roth IRA’s, home equity, etc.), then tax discounting will usually be applied. For example, imagine your only two assets are $50,000 in retirement and $50,000 in cash. Are these assets equal? If you apply tax discounting, then the answer is ‘no’. Again, this is because if you cashed in the $50,000 in retirement you might pay 25% taxes, which would leave you with $37,500. It should be noted that not all professionals agree that tax discounting is appropriate. Oregon lawyers and mediators usually apply tax discounting, although not always.
Other situations where some version of tax discounting may apply include:
- Taxable investment accounts. If you have stocks, bonds, etc., that are not held in a retirement account, these investments might have either short-term or long-term capital gains. Short-term capital gains are taxed at ordinary income rates. Long-term capital gains are taxed at capital gains rates (0%, 15% or 20%).
- Rental/Investment Properties. Real estate that is held for investment is subject to capital gains taxes when it is sold.
- Businesses. Businesses that are sold are subject to capital gains taxes at the time of sale.
Note: In Oregon, tax discounting usually only applies to the sale of businesses and real property if the sale is certain to happen in the relatively near future. As with just about everything, the specifics of your situation should be discussed with your attorney.
Importance of Tax Rate. When we are dealing with tax discounting, the assumption that you make about the tax rate is very important. Sticking with the $50,000 retirement example, if we assumed a 19% tax discount (10% Federal, 9% State), then $50,000 is only “worth” $40,500. If we assumed a 42% tax discount (33% Federal, 9% State), then $50,000 is only “worth” $29,000. Using this example, you can see the importance of choosing an accurate tax rate. Unfortunately, this is not necessarily the easiest thing to determine accurately, particularly since it requires speculating what someone’s future tax rate will be, not just their current tax rate. The following terms may be helpful in understanding some of the complexities of determining your tax rate.
Marginal Tax Rate vs. Average Tax Rate. When people think of their tax rate, they usually think of their “marginal” tax rate. Marginal tax rate is the tax rate that applies to all dollars earned in a particular tax bracket; this is your “top” tax rate. However, you don’t pay your marginal rate on all money that you earn – you pay a lower rate on amounts you earn in a lower tax bracket. For example, in 2016 someone filing “single” will pay 25% federal income tax on amounts earned between $37,651 and $91,150. But, that same person pays 10% on earnings between $0 and $9,275, and 15% on earnings between $9,276 and $37,650. So a person who earns $40,000, will only pay 25% on $2,349 ($40,000 – $37,651). Note: This example does not account for dependency exemptions, personal exemptions, itemized deductions, etc.
The average tax rate is the total tax you paid divided by your total income. So if someone earns $40,000 and pays a total of $5,500 in taxes, then their average tax rate would be 13.75% even though their marginal tax rate is 25%.
You should discuss whether to apply your marginal tax rate or average tax rate with your tax professional, attorney or financial advisor.
“Grossing Up.” Often someone will owe a property settlement and the only asset available to pay the settlement with is an IRA or 401k. Since we know that retirement accounts are worth less after you discount them for taxes, the question is, what is the amount needed to get someone a certain amount after taxes are factored in? Luckily, there is an equation for this.
The equation is: (Amount owed) / (1 – Tax rate)
Example: $50,000 / (1 – .24) = $65,789
This means that if we need to get someone $50,000 and that person’s assumed tax rate is 24%, then it would require transferring $65,789 from a 401k.
Avoiding The Issue. In practice, we usually try to divide assets in a way that evenly distributes tax consequences between the parties so that you can avoid having to deal with tax discounting. If both people evenly share the tax consequences, then we don’t necessarily care what the tax consequences are because they will apply (more or less) evenly to both people.
Based on the above examples, you can probably see the significance of assuming an accurate tax rate. Unfortunately, this is a difficult thing to accurately predict. It requires us to accurately assume 1) someone’s future income and, 2) what tax rates will be in the future. If the assumptions are inaccurate, then someone can potentially ‘overpay’ or ‘underpay’ significantly. How can we avoid this? This can be avoided by not trading one kind of asset for a different kind of asset. In other words, this can be avoided by splitting each type of asset class in half. Note: It may not always make sense to split an asset in half. Further, “splitting the asset” refers to splitting the “marital portion” of the asset. If someone has a premarital retirement account, the premarital portion wouldn’t typically be split (although it could be).
Continuing with the above example, we can avoid tax discounting if each person receives $25,000 in retirement and $25,000 in cash. If each person receives half of each of these assets, then no tax discounting is required because each person is getting half of everything, including the tax consequences.
This is a general overview of this subject which is designed to give you a basic understanding of the issue of tax discounting. This article is not tax advice and should not be construed at such. If you need tax advice, you should consult with your CPA or other tax professional. Further, it is important to realize that all situations are different and that it might not be appropriate to apply a tax discount in a particular situation.