What is Tax Discounting?

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“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.

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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.

Health Insurance, Divorce and the Affordable Care Act

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One of the biggest concerns for people going through divorce is losing health insurance. The Affordable Care Act (aka “Obamacare”) significantly changed the way health insurance is dealt with in divorce. In short, the Affordable Care Act makes it much easier to obtain health insurance coverage after you go through divorce. Here are the basics that you need to know:

Open Enrollment. Open Enrollment is the period of time when you have to apply for health insurance unless an exception applies (called a “special enrollment period”). The open enrollment period for 2016 is November 1, 2015 through January 31, 2016.

Special Enrollment Period. You can apply for health insurance during a “special enrollment period” if you have 1) a qualifying life event or 2) other complicated situation.

Qualifying Life Event. There are many different qualifying events. The one that most commonly applies in a family law situation is divorce. Other qualifying life events that may occur during the divorce process include loss of job, loss of health insurance coverage or significant reduction in income. If you do not qualify under one of these scenarios, you should determine if there are other qualifying life events that may apply in your situation. If you are not eligible under a qualifying life event, then you should determine whether you can apply as a “complicated situation.”

Complicated Situation. If you have a particularly complicated situation but do not have a “qualifying life event”, you should discuss your circumstances with a health insurance broker or other HealthCare.gov worker. Your circumstances may still qualify you for a special enrollment period. Domestic abuse and spousal abandonment are two situations which may qualify as a complicated situation. There are potentially other situations which may qualify you as well.

COBRA. COBRA is a federal law which was the basis for maintaining health insurance after divorce prior to the passage of the Affordable Care Act. COBRA allows you to maintain the same health insurance plan you have had for up to 36 months. However, COBRA is often expensive and does not apply in all situations (e.g., the employer must have at least 20 employees). COBRA may still be a good option if you need to maintain your specific health insurance plan.

Tip: You may be eligible for COBRA through your soon-to-be-ex’s employer and a private policy through the Affordable Care Act. You should check to see how much COBRA costs and compare it to the cost of a plan through the Affordable Care Act. Cost is obviously a significant consideration, but you should also compare the level of coverage and whether your preferred healthcare providers are covered under the new plan.

Tip: You can apply for health insurance through Healthcare.gov on your own or you can work with a health insurance broker (some states run their own individual exchanges although Oregon no longer does). You do not pay a health insurance broker for their services. Health insurance brokers get paid by the insurance companies. It may make sense to work with a broker since there is no additional cost to you and they know how to navigate the health insurance system. One health insurance broker you may consider using is Portland, Oregon based Century Benefits.

End of Prior Coverage. Generally speaking you will continue to be covered under your ex-spouse’s health insurance through his or her employer through the end of the month in which the divorce is final. However, some employers will terminate coverage for a now-former spouse immediately upon learning about the divorce. It is important for the employed spouse to check with the employer before the divorce is final to learn when the ex-spouse will be removed from coverage. This information should be shared with the spouse who will be losing coverage.

Legal Separation. It is fairly common for people to get a legal separation rather than a divorce so that the former spouse can continue health insurance benefits. If you are considering a legal separation for health insurance reasons it is necessary that you check with your employer to determine whether the employer treats legally separated spouses as married or as divorced. Your employer’s HR department should be able to provide you with this information.

Summary. It is much easier to obtain health insurance after a divorce than it used to be. However, there are specific timelines that may apply to your situation. It is important that you obtain information about health insurance before you get divorced so that you have a plan for insurance once the divorce is final. You can obtain more information through OregonHealthCare.gov or HealthCare.gov.

This is only an overview. You should discuss the specifics of your situation with a health insurance broker or other health insurance professional.

What You Need to Know About “QDROs”

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This is a guest post by Clark Williams of Heltzel Williams, P.C. Clark is a QDRO attorney and also practices business law.  Clark can be reached at 503-585-4422.  Please note that Forrest Collins is not a QDRO attorney and is therefore unable to assist in the drafting of QDRO’s.

So, you are about to be divorced or legally separated and one of the assets to be divided is a retirement plan sponsored by your employer or your spouse’s employer.  Your lawyer says that you need a “QDRO” (pronounced “qua’-dro”) to make the split, and that a specialist is required to draft it.

You ask your lawyer:  “What is a QDRO, and why can’t you do it?”  Those are good questions!  This article is intended to answer those and other basic questions about dividing retirement plans in divorce.

  1. Why can’t the retirement plan be divided or transferred just like a bank account or an investment portfolio?

Because retirement plans are uniquely protected assets under federal law.  Generally speaking, these plans are exempt from all legal process, period.  They are “bullet-proof.”  No creditors can reach them.  You can go thru bankruptcy, lose everything else you own including your house and car, but you won’t lose your retirement plan.  Congress has determined that it is more important for people to reach retirement age with their retirement benefits intact, to support them in retirement with more than just Social Security.

Before 1984, retirement plans were exempt from divorce, too.  But in 1984, Congress made a special exception, allowing retirement plans to be divided between spouses in the context of a divorce or legal separation, if ordered by the divorce court in a “qualified domestic relations order,” or QDRO.

  1. So, what is a QDRO?

A QDRO is a separate court order that is drafted specifically for the retirement plan to be divided.  The QDRO must be very complete about the how the retirement benefit is divided, and it must consistent with the terms of the retirement plan itself.

  1. Why must my lawyer hire a specialist to draft the QDRO?

Because it is very complicated.  Every retirement plan is different.  There are many different types of retirement plans – – profit sharing, 401(k), pension, defined benefit, employee stock ownership plans, deferred compensation and others.  Some plans make lump sum payments, others pay just a monthly payment in retirement years.  And, as stated, the QDRO must be drafted in a way that is consistent with the terms of that retirement plan.  The QDRO cannot require a retirement plan to pay the former spouse more than, or sooner than, or in a form other than, the plan would otherwise pay to the participant.  So drafting the QDRO takes someone who understands pension law, the type of plan being divided and the particular terms of the plan.  Most divorce lawyers don’t have that level of expertise.  Rather, to prepare a QDRO correctly and efficiently, it usually takes an expert who handles retirement plans and QDROs as a regular, every day part of his or her law practice.

  1. Might I need more than one QDRO?

Yes.  Generally, a separate QDRO is required for each retirement plan being divided.  So, for example, if you have a 401(k) plan and your spouse has a pension plan, and if the divorce calls for both retirement plans to be divided, then two separate QDROs will be required, one for each plan.

  1. So, what is the normal process for a QDRO?

First, when the divorce case is concluded, the judgment of dissolution will specify in general terms how the retirement plan is divided, e.g., “wife is entitled to 50% of husband’s 401(k) plan as of the date of the judgment. “  But this general language is not enough for the retirement plan to act on – – the plan needs a QDRO.  So shortly following the judgment, the QDRO lawyer will draft the QDRO specific for that plan and send it to the plan administrator for preapproval.  Most plans have a process for reviewing and approving QDROs in advance of being signed by the judge.  Again, every plan is different, so some plans will require changes that other plans won’t require.  Once pre-approved by the plan administrator, the QDRO lawyer will send a final copy of the QDRO to the divorce lawyer to be signed by the judge.  And once signed by the judge, a court-certified copy of the QDRO is sent back to the plan administrator for final approval and implementation. Then the plan administrator will start the process of segregating the portion of the retirement plan benefit that now belongs to the former spouse.

  1. So how long does this all take?

The usual QDRO process, from start to finish, is three to six months, and that assumes it goes smoothly and everyone cooperates.  The process involves a lot of people – – the two parties, their lawyers, the QDRO lawyer, the plan administrator, and the judge.  Everyone has to do their job timely.  If the process gets hung up anywhere along the way, which often happens, it can take even longer.  So you can’t be in a hurry for it.  If you are the former spouse and you are expecting money out of the QDRO (e.g., you are getting some of your spouse’s 401(k) plan), don’t spend the money before you receive it.

  1. What are the tax aspects?

Like any distribution from a retirement plan, payments to a former spouse pursuant to a QDRO are taxable when received.  Any amount taken will be subject to automatic 20% federal tax withholding, to be credited against the former spouse’s final tax bill for that year.  Oregon law provides for 8% withholding, but that is waivable if the former spouse would rather pay the Oregon taxes with the tax return.  And there is one tax-break: the usual 10% tax penalty for early distributions (under age 59½) from a retirement plan does not apply to a distribution pursuant to a QDRO.  So if the former spouse is needing the money for other reasons (e.g., to pay debts or lawyer fees or to buy a new house), taking a lump sum distribution pursuant to a QDRO will avoid the 10% penalty, even if the distribution is still subject to income tax.   Or if the former spouse would rather defer all taxes, the former spouse can “rollover” any lump sum distribution tax free to an IRA where the funds can remain invested and continue to grow tax free until retirement.

Comparing Divorce vs. Legal Separation

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People often ask what the difference is between legal separation and divorce.  Sometimes they will even ask, “Should I file for divorce or legal separation?”  This is clearly a very personal choice and not a decision someone else can make for you.  With that said, here is what you need to know:

If you are legally separated you are still married.

The main difference between divorce and legal separation is that you are still technically married if you are legally separated.  This means, amongst other things, that you cannot get married to someone else while you are legally separated.  Other than that, legal separation looks very similar to divorce.  In fact, you can make all of the same provisions in a legal separation that you can in a divorce.  For example, you can create a parenting plan, divide pensions, award the home to someone and establish spousal support.  Basically, anything you can do in a divorce you can do in a legal separation.

It is important to understand that the terms of your legal separation will continue to apply if you get divorced unless you both agree to change the terms.  In other words, it is very important that you are comfortable with the terms of the separation now because you probably will not be able to change them later on.

Why get legally separated?

Health Insurance.  The most common reason people get legally separated is because they want to proceed with divorce but they need to be able to maintain health insurance.  Important: Check with your company to make sure that you can cover a legally separated spouse under your health insurance.  Some companies do not allow you to you maintain health insurance for a legally separated spouse.  If you are considering legal separation for health insurance reasons, check with your company first to make sure you are able to maintain coverage.

Religious Reasons.  If you are legally separated you are still married.  Some people find legal separation preferable to divorce based on their faith.

Trial Separation.  Sometimes people will enter into a legal separation as a true trial separation, i.e., they want to see if the marriage can work but want to make sure there are agreements in place about the separation.  This is not a very cost effective way of trying out a separation.  If you really want to try to make your marriage work, you can save yourself a lot in legal fees by separating households and actually trying it out.  Further, the formality of a legal separation combined with working with divorce attorneys may actually make it more likely that your trial separation leads to divorce.

Liability.  In certain situations people are concerned about liability issues related to their spouse.  For example, they may be concerned that their spouse may injure someone in a car wreck and they themselves will be liable.  A legal separation may insulate you from spousal liability to some degree, but as long as you remain married you run the risk of being liable for damage or injury caused by your spouse.

Converting legal separation to divorce.

It is fairly simple and straightforward to convert a legal separation into a divorce.  If you have been separated for less than two years you can simply file a motion asking the court to convert the separation to a divorce.  If one person objects to converting it to a divorce, then a hearing will be set and the divorce will be granted.  If you have been separated for more than two years, it is still easy enough to convert a separation to a divorce but it does require some additional paperwork.  Mediation tends to be a very efficient way to convert a legal separation into a divorce.