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PENSION EVALUATIONS

RECOGNITION OF FEDERAL INCOME TAX CONSEQUENCES

HOW TO CALCULATE THIS TAX CONSEQUENCE

ALERT.

THIS ARTICLE IS FOR INFORMATION AND EDUCATIONAL PURPOSES ONLY. It is not offered as a representation of Troyan's opinion.

To better understand the full process, we begin with a traditional pension evaluation. Once the pension's value has been determined, the next step of the attorney representing the participant spouse is to compute the "tax offset" to the present cash value indicated in a Traditional Pension Evaluation report.

This article does not challenge the validity of a Federal Income Tax Offset. To the contrary, The attorney representing a Participant spouse has a duty to protect the financial interest of the client. Troyan's concern is not with the application of an Immediate Offset Settlement format, rather it is with the Participant attorney's failure to recognize the "tax cost" of this settlement to the client.

It is to the financial detriment of the Participant for her or his attorney to accept a pension evaluation that fails to also offer a "tax consequence" calculation. The result of reducing the present cash value of the pension by the present cash value of the tax consequence (that begins at the point of retirement) may be termed "Net Present Cash Value".

This second step which produces the "Net Present Cash Value" is the subject of this article.

An Immediate Offset Settlement Requires calculation of the present cash value of the Participant's monthly accrued benefit as of either:

  • Date Action for Divorce Filed or,
  • Date of Divorce

This article uses: Date Action for Divorce Filed

The process begins with a Traditional Pension Evaluation Report.

Step I. Calculation of the Marital Present Cash Value of the Pension.

The relevant portion of a evaluation provides the following facts and data.

Plan Name: Florida Regular Class Employee

Plan Participant: Tom Walther

Date of Birth: 4/1/1973

Normal Retirement Age: 62

Current Annual Compensation: $88,000.00

Date of Hire: 4/1/1998

Date of Marriage: 4/1/2000

Date Action for Divorce Filed: 4/2/2018°

°(April 1, is a Sunday)

Based on these statistics, the Plan's features and its investment rate of return (interest rate assumption) the following was calculated.

Tom's monthly accrued benefit on 4/2/2018: $2,346.67

Coverture Fraction on 4/2/2018: 90%

(18 yrs. ÷ 20 yrs. = 90%)

Marital Monthly Benefit on 4/2/2018: $2,112.00

Present Cash Value of Marital Monthly Benefit: $73,411.00

Now that the Marital portion of the Pension 's Present Cash Value has been established we may apply the following.

IMMEDIATE OFFSET METHOD.

Step # 1.

Calculate the marital present cash value of participant's pension as of either the Date Action for Divorce Filed or Date of Divorce.

Step # 2.

Multiply the Step I, value by the Coverture Fraction.

The symbol "*" means "multiply by"

($2,346.67 * 90% = $2,112.00)

Step # 3.

Calculate the present cash value of the Step # 2 benefit.

Present Cash Value of Marital Benefit: $73,411.00

Step # 4.

Equally divide the marital present cash value: $36,705.51

($73,411.00 ÷ ½ = $36, 705.51)

The Wife, Jane Walther, is then awarded an asset of equal value to her share of Tom's pension. Jane then in exchange for this alternate asset, waives her interest in Tom's pension. Jane has received an asset of equal value.

When representing the Participant spouse, it is essential to deem a pension evaluation akin to the above as incomplete.

This Second Step, produces the ""Net Present Cash Value" of the Marital Pension, i.e., the present value less the present value of the income taxes attributable to the "Alternate Payee's waived portion of the pension.

The Vital Second Step in the Valuation Process.

A traditional Immediate Offset pension evaluation is only the initial set of calculations. This is followed by a second virtually identical set of calculations that quantify the federal income tax consequences that impact on the pension spouse at retirement and produces the "Net Present Cash Value" of the Marital pension.

The basis for this Tax Consequence Calculations is found at:

Internal Revenue Code Section 1041(a)(2), which provides as follows:

No gain or loss shall be recognized on a transfer of property from an individual to…(Emphasis mine)

(2) a former spouse, but only if the transfer is incident to the divorce.

Based on the above citation from the U.S. Code and provisions of this settlement, Jane received a "tax free" asset transfer in the amount of $36,706.00. Yet, when Tom retires and receives that portion of the pension waived by Jane, he will pay the Federal Income Taxes on Jane's waived portion of the pension (which he now receives, since Jane got a cash award and Tom kept his full pension).

It is essential that the family practitioner, be clear on the above paragraph. This is the basis for the second or Tax Offset calculation. What is emphasized here is the fact that the Alternate Payee waives a right to a portion of the Participant's pension in exchange for another asset. This alternate asset is tax advantaged due to 26 U.S.C. 1041. However, the tax advantage does not extend to the Participant. The Participant will now be liable at each year (subsequent to retirement) for the income tax attributable to the portion waived at divorce by the Alternate Payee. This circumstance is the basis for the "Net Present Cash Value" argument.

Be Alert To This "Simple" Solution.

At this point the attorney representing the participant spouse suggests that the appropriate calculation is to reduce by ⅓ the marital present cash value. That produces the correct "Net Present Cash Value".

Step # 1. Reduce the given marital present cash value by ⅓ .

.

$73,411.02 * ⅓ = $24,467.89

Resulting "Net Present Cash Value:

$73,411.00 - $24,467.89 = $48,943.12

Then award to the wife half of the "Net Present Cash Value".

Step # 2.

Wife Award Less offset: $48,943.12 * .5 = $24,471.56

The perspicacious reader, may find the above method pregnant with flawed reasoning.

Reason: It fails to consider and account for the inevitable tax impact to the participant upon retirement (and thereafter for the balance of the retiree's lifetime. Since this tax impact is annual, it follows that an appropriate offset to the present cash value shown in an Immediate Offset pension evaluation all also consider:

Each year's tax consequence attributable to what would have been the Wife's monthly benefit.

In effect, what must be performed is a second stream of calculations. The present cash value of this stream is then subtracted from the present cash value of the marital pension benefit. The result is: Net Present Cash Value.

Net Present Cash Value = Present Cash Value of Pension Minus Present Cash Value of Annual Tax

The Attorney For Plan Alternate Payee's Argument.

Commentary.

A recent publication of the Tax Foundation, citing Internal Revenue Service statistics indicated that the average percent of income tax paid on Adjusted Gross Income is 14.16%. This average percent of tax paid is used in the calculations and discussion that follows. Clearly, the actual federal income tax applicable to your specific matter will vary. Admitted there are many factors that can impact on the tax cost. Our aim here is to illustrate a concept. Once the concept is understood, the statistical and personal factors relevant to your unique case may be applied.

Known Data:

Total Monthly Benefit at end of marriage: $2,346.67

Coverture Fraction: 90%

Marital monthly benefit payable at Toms age 62: $2,112.00

Jane's monthly benefit payable at Tom's age 62: $1,056.00

Present Cash Value of Jane's monthly benefit: $36,705.51

($73,411.02 * .5 = $36,705.51)

Note: For the source of the $73,411.02, see "Step I, above".

Significant Observation.

No tax will be imposed on Tom's pension, until he retires at age 62. [1] Thus, the argument of Jane's attorney for an "Immediate Tax Offset" is baseless. Income taxes begin subsequent to the retirement of the Participant. The Participant's calculations are based on the present value of the pension, i.e., a sum that is never to be distributed. Remember this is a Defined Benefit Plan, payments are not made in a single lump sum. Payments are made in the form of an annuity (periodic payments, usually monthly) commencing upon Participant's retirement.

For purposes of the article we have applied the "average" tax rate indicated above. Based on this assumption of an effective tax rate of 14.16% of Adjusted Gross Income, the tax attributable to Jane's annual distribution of $12,672.00 is $1,794.36. It is then assumed that this annual tax would be paid by Tom over his actuarial life expectancy. For actual cases a more sophisticated process is applied to impute the effective tax rate. [2]

Depending on the Plan, the calculation of present cash value is based on:

State Plans: Actuarial Assumption of System

Municipal Plans: Actuarial Assumption of System

Federal Plans: Actuarial Assumption of System

ERISA Plans: Most Recent "Segment Rates [3]

The "Immediate Annuity Cost" [4] of this monthly benefit at Tom's age 62 is: $17,782.46.

Note. This is the value of the benefit at Tom's age 62.

The next step is to discount the age 62 value back to 4/2/2018 (Valuation Date).

This present cash value on 4/2/2018 is: $5,118.98 [5]

Based on this calculation the Immediate Offset amount to be paid to Jane on April 2, 2018 is calculated as follows:

Pension's Marital Present Cash Value: $36,705.51

Present Value of Tax Cost: $5,118.98

Net Amount of Award to Jane: $31,586.53

Tom's calculation of amount due Jane: $24,471.56

Difference: $7,114.97

Conclusion:

In compliance with the view that "Burden follows Benefit", it is appropriate to recognize and apply a Federal Income Tax Offset to the pretax value of Jane's award, so Jane receives in the Immediate Offset Settlement the Net Present Cash Value Equivalent of her portion of the pension.

For the attorney representing the participant spouse to disregard this process is contrary to the client's financial interests.

This article acknowledges the reality of a Federal Income Tax Consequence and the necessity for an Offsetting Tax Calculation. The attorney representing a Participant spouse has a duty to conflate these to Valuation components in order to protect the financial interests of the Participant. Troyan's concern is not with the application of an Immediate Offset Settlement format. Rather it is with the potential for the Participant Spouse's attorney's to fail to integrate a "tax cost" offset into the overall settlement of the pension issue.



[1] Naturally, in your specific matter this age can vary. To avoid confusion and absent compelling data to the contrary, it is suggested that the default Retirement Age assumption be the Participant's Normal Retirement Age as specified in the Plan Document or Statute.

[2] In many instances, the best data source of effective tax rate are recent tax returns of the Participant.

[3] 26 U.S.C. 417(e)(3)(D).

[4] Immediate Annuity Cost: This is the single sum required at retirement to purchase an annuity in the amount of the promised pension to the retiree and is payable over her or his lifetime.

[5] This value is termed "Discounted Present Cash Value".