October 6, 2021 – This is a wakeup call to family attorneys and their clients to urge both to consider what is inside brokerage accounts and not just look at account titles and balances.
Your attorney may only look at the balance of your brokerage account and your investment company may only report current market values. Without proper financial analysis, this could mean an unequal division due to capital gains taxes that are due upon sale.
Here’s the story of Ken and Ellen: Ken is a mid-level corporate marketing executive while Ellen was a stay-at-home mom for most of their 30-year marriage. Both were 60 when they divorced. Ken was awarded half their cash on hand and his 401k at work. Ellen was awarded half the cash on hand and their joint brokerage account. The husband’s attorney insisted that the 401k be discounted 25% because withdrawals would be taxed at ordinary tax rates and 25% was Ken’s expected top tax rate.
The joint brokerage account was roughly the same size as Ken’s discounted 401k. Ellen’s attorney told Ellen to take the brokerage account because it was more liquid, meaning it could more easily be converted to cash. However, the brokerage account had significant unrealized gains that would be taxed at capital gains rates as Ellen liquidated the account. The brokerage account could have been similarly discounted.
Here’s what their division looked like:
However, the unrealized gains in the brokerage account were 80% of the account value, which was not considered by the attorneys. The after-tax value of the brokerage account if a 15% discount were taken is only $637,500. If this was considered, the division might look very different.
If a 15% discount had been applied to the joint brokerage account, Ellen would have $60,000 more than before if the desired outcome is a 50/50 split.
After the divorce Ken went on to work another 8 years and continued to contribute to and grow his 401k. Meanwhile, Ellen needed the brokerage account for living expenses. It was difficult for her to cut her living expenses so quickly after the divorce. Ellen also kept the couple’s three aging dogs who needed constant and expensive care. She withdrew $8,000 a month from the joint brokerage account. The tax expense increased her budget by nearly $12,000 a year.
Meanwhile Ken never withdrew from the 401k or even experienced a 25% tax expense due to an inheritance 3 years after the divorce. When he passed 15 years after the divorce, the 401k now worth more than twice the value, was left to his new wife.
This case leaves more questions than answers. Is 25 % the right discount to be applied to the 401k? If Ken only need to withdraw $40,000 a year to supplement his social security based on his annual expenses, the average tax rate might be more like 10-12%. If Ken planned to work for 8 more years, should we discount the tax expense from future years, which also lowers the rate.
Could an analysis be done to determine when and how much Ken might need to withdraw from the 401k per year? Should the potential for inheritance be considered when determining the amount of discount applied to the 401k?
Answers are different for each divorce, but these are issues that should be analyzed by financial professionals. Hiring a Certified Divorce Financial Analyst® (CDFA) might have been well worth the expense.
Other Potential Pitfalls to Look for in Your Brokerage account
There are types of investments inside some brokerage accounts that can make dividing it more difficult. Private investments may require a minimum net worth to subscribe. Dividing this type of investment between two spouses (who now have half the amount of net worth they had as a couple) can be tricky and may even require the investment be held jointly until liquidation. As this type of investment is typically difficult to value and held for many years before they can be liquidated, spouses may be forced to be partners. Also, some investments have a minimum investment size (like treasury or some corporate bonds) and can’t be divided in two without a cash offset. Lastly, a brokerage account may be ‘pledged’ to support a line of credit, like how a home is pledged to a home equity line of credit.
Family law attorneys rely on CPAs, tax professionals, and forensic accountants for financial analysis. However, these professionals may not be familiar with the structure of today’s brokerage accounts. When dividing brokerage accounts, attorneys and their clients may want to consult with existing advisors or knowledgeable financial professionals, like CDFAs, to determine how best to deal with each of these potential issues.
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