The trade – the marital residence for retirement assets is very common in divorce settlement agreements. Often times it driven by one parties desire to keep the home and the only other major asset that is available to compensate the other spouse are retirement assets.
When you do make this trade make sure that you consider the tax issues associated with each asset as the net result may be very different than you thought. If the trading value is based on the value of the equity in the home for an equivalent value of retirement assets, which is a typical way to look at it, the results, as you sell the assets, will be very different.
Let’s set aside the potential for increase in value of either the marital residence or retirement assets and the wisdom of keeping the house from a maintenance perspective for the moment, those are discussions for another day, and just look at the taxation of either asset.
When you sell the marital residence, unless you purchase another real estate asset (1031 exchange for you technical folks), you will be taxed on the capital gains associated with the house. Each person has a lifetime capital gains exemption of $250,000 on their primary residence. What this means is the first $250K of the capital gains (assuming you have not used any of this exemption in the past) will be tax free.
If equity in the house is worth $650,000 (current value with no mortgage) and you trade $650,000 of retirement assets your results will be very different on an after tax basis.
Example: You purchased your home for $150,000, did some renovations (new kitchen and bathroom for $75,000 and a new roof for $25,000) giving you a cost base of $250,000 for your house. You sell the house for $650,000 giving you a capital gain of $400,000. As an individual the first $250,000 is tax free and the remaining $150,000 will be taxed, depending upon your income, at a rate of 10-20%. In a worst case (20% tax rate) your net cash from the house would be reduced by $30,000 in tax liability.
If you are taking retirement assets in lieu of the house the tax status of the retirement funds is essential to know. Are these assets in a tax deferred form (IRA or 401K) or are they Roth IRA assets.
If the assets are in a Roth account (not typical) then, presuming you are 59 1/2 when you withdraw the funds from the account and you have held them for at least 5 years they will be tax exempt and you will be in a slightly better position with these assets than with the marital residence.
If the assets are the more traditional IRA or 401K retirement assets then you are taxed on the withdrawals as current income. This means that the $650,000 you traded for the marital residence is $650,000 less taxes of 15-39% depending upon your tax bracket. Big difference.
Examining the tax impact of your financial decisions is very important as home equity is not equivalent to retirement assets on a dollar for dollar basis. If you are going to make this trade keep this in mind as you prepare for your divorce.