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Retirement Accounts in Divorce

The typical divorce case involves a mix of assets including a family home, some bank accounts, some investment accounts, and some retirement accounts and retirement benefits. Retirement accounts and benefits are inextricably linked with tax law, which makes them complex by nature. Because so much wealth is tied up in retirement accounts and benefits, it’s vital to understand what you are dividing so you can reach a settlement that won’t backfire on you down the road.

This article is longer than some of my others as the topic is more complex. However, not every account type is found in every case, so I encourage you to read only about the account types you own.

Framework for Understanding

Before we get into the weeds, I want to build a framework for you to understand the different types of retirement accounts and retirement benefits. They can be employer sponsored (tied to your or your spouse’s employer), or they can be on an individual basis (tied to an individual only). 

Retirement accounts and benefits can also be defined benefit (the plan promises a specific benefit at a future date), or they can be defined contribution (the plan promises a specific contribution amount, but does not guarantee a specific future benefit). 

Retirement accounts all come with strings attached with respect to withdrawing money.

The typical rule of thumb is that you can’t tap into retirement accounts without a penalty until you attain age 59½. Even after you attain age 59½, you’ll still owe income taxes on money you take out of a retirement account.

Lastly, different retirement accounts and benefits are divided using different processes. Those processes can be very slow (Qualified Domestic Relations Orders) or relatively quick (Letter of Instruction), so you’ll want to consider timelines when dividing your estate as well.

401(k) and 403(b)

What is it?

The 401(k) plan and its lesser-known cousin the 403(b) plan are relatively well understood by most clients. These are employer sponsored defined contribution plans where the employer and employee typically make monetary contributions. The plan makes no guarantee about the value of the account in the future. The money contributed to the plan is invested at the direction of the plan participant (the employee). 

What you need to know

401(k) plans and 403(b) plans are divided using a document called a Qualified Domestic Relations Order (QDRO). This document is separate and apart from your Divorce Decree. It could take weeks to draft and months to be processed by the courts and the plan sponsor (the employer). Once the QDRO has been fully processed, the employer sponsoring the plan will open a plan account with your name on it. In this case, you are referred to as the alternate payee. Once your new account is created and funded, you’ll often have three options:

  1. Take a lump-sum distribution: Taking a lump-sum distribution is almost always a bad idea. Doing so will make the entire account balance subject to income taxation in the year of distribution. In addition, if you have not attained age 59½, you will be subject to an additional 10% tax penalty. Not only does this destroy wealth — it can also bump you into a higher marginal tax bracket since the entire distribution is considered income.[1]
  2. Leave the assets in the account: This can be a great option if you don’t need the money right now and don’t have a compelling reason to rollover the assets to a Rollover IRA or your own 401(k).
  3. Rollover your assets to your own 401(k): If you have your own 401(k) with your current employer, and if that plan accepts incoming rollovers, you can elect to rollover these assets to that plan. This can be a great way to consolidate assets and simplify your life. A direct rollover has no tax consequences.
  4. Rollover your assets to a Rollover IRA: Some clients choose to execute a direct rollover to a Rollover IRA in order to consolidate assets or access professional investment advice. A direct rollover transaction has no tax consequences.[2]

In general, assets in a 401(k) plan can’t be accessed without penalty until you attain age 59½. If you take money out before that time, you will be subject to a 10% penalty in addition to income taxes. Once you attain age 72, if you haven’t started taking money out, the IRS will require that you begin taking Required Minimum Distributions.[3]

There is a workaround for the 10% penalty if your QDRO is drafted properly. That is a key reason to use a financial professional in your settlement negotiations. If you need access to assets and the only thing on the table is a 401(k), a professional like a Certified Divorce Financial Analyst™ (CDFA®) can recommend that you integrate this into your QDRO.

Pension

What is it?

A pension is an employer sponsored defined benefit plan. The typical pension promises a stream of fixed payments (usually monthly) starting when the employee retires and ending with the employee’s death.

What you need to know

Like 401(k) plans, pension plans are divided using a Qualified Domestic Relations Order (QDRO). Also as with 401(k) plans, once your QDRO is fully processed, the employer sponsoring the plan will open a pension benefit account with your name on it.[4] There are two methods for divvying up a pension benefit, and the method used for your case can be vital to your immediate and future financial health.

Shared Interest

A shared interest QDRO allows the alternate payee (that’s you) to receive benefits when, and only when, the participant (that’s your ex-spouse) begins receiving his or her benefits. That means if you are the younger spouse and you need the pension income to sustain yourself, you’ll have to wait until your ex-spouse turns on his or her own benefits. Shared interest QDROs are best for pensions that are already in pay status – that is, the participant is already receiving benefits.

Separate Interest

A separate interest QDRO allows the alternate payee (that’s you) to receive their share of the pension benefit commencing at any time that the participant (that’s your ex-spouse) is entitled to receive his or her own pension benefit. That means you can turn on your benefit when your ex-spouse reaches the plan’s early[5] or normal retirement age. Here you are only waiting for your ex to age, not retire, before you can receive benefits.

 Regardless of how your QDRO is written or when you take benefits, those benefits will be subject to income tax in the year received, just like a paycheck.

Individual Retirement Arrangement (IRA) Account

What is it?

An Individual Retirement Arrangement account, better known as an IRA, is exactly what the name sounds like: an individual retirement account. They come in three flavors, and each flavor has its own variation on the basic rules.

What you need to know

Regardless of the flavor, IRAs are generally divided using your Divorce Decree and a Letter of Instruction signed by the IRA owner (your ex-spouse) and addressed to the financial institution where the IRA is held (often call the IRA Custodian). Once your Divorce Decree has been entered with the court and a certified copy is available, the division process can take a few days or a few weeks. Upon receipt of a certified copy of your Divorce Decree and Letter of Instruction and signed account opening forms[6], the IRA Custodian will open a new IRA account with your name on it and transfer the assets awarded to you into the new account. Once your new IRA is funded, it is up to you to determine how the funds in the account will be invested. If getting access to assets quickly post-divorce is important, and there are only retirement accounts on the table, consider asking for IRA assets before 401(k) or pension assets. 

Now let’s dig into need-to-knows for each flavor of IRA:

Rollover

This is an IRA that was funded using the proceeds of a 401(k) Rollover. Because all of the funds in the account are pre-tax dollars, all funds distributed from the account will be subject to income taxation in the year of distribution. As with other retirement accounts, distributions taken before you attain age 59½ will be subject to an additional 10% penalty. Distributions, no matter when they are taken, are subject to income tax in the year of distribution.[7]

Traditional

This is an IRA that was funded with annual contributions from the IRA owner. Because some of the funds in the account may be post-tax, not every dollar distributed is automatically subject to taxation. However, unless your ex-spouse kept scrupulous records (that you can access), it may be difficult to prove the amount of post-tax dollars in the account. As with other retirement accounts, distributions taken before you attain age 59½ will be subject to an additional 10% penalty. Distributions, no matter when they are taken, are subject to income tax in the year of distribution.[8]

Roth

This is an IRA that was funded with annual contributions of post-tax dollars from the IRA owner. A Roth IRA is special because normal distributions are not subject to income taxation.[9] As with other retirement accounts, distributions taken before you attain age 59½ will be subject to a 10% penalty.

Annuities

Annuity contracts aren’t officially a type of “retirement account,” but I’ll address them here briefly because they are often treated and used as one.

What is it?

An annuity is a contract between the contract owner and an insurance company. These contracts come in a variety of flavors, and addressing each is well beyond the scope of this article. The key elements of an annuity contract to keep in mind when dividing an estate are the owner (the person or persons listed as owner) and the annuitant (the person on whose life any living or death benefits are based). For example, a couple may own a contract jointly – both are listed as owners – but the annuitant is the husband; all benefits[10] associated with the contract are based on the husband’s life.

What you need to know

Like a 401(k) or pension plan, an annuity is divided using a QDRO. Because division or re-assignment of annuities is relatively uncommon, it’s wise to use a QDRO specialist to draft this particular type of QDRO. When dividing or re-assigning an annuity, keep in mind that, in general, you can change the annuity owner, but you likely can’t change the annuitant.

As with our example above, the jointly owned contract could be changed to an individually owned contract, but any living benefits or future death benefits would still be based on the life of the original annuitant. In addition, the insurance company that sold the contract may have rules that govern the transferability of a contract. Check with the annuity issuer before agreeing to change ownership on an annuity contract. Lastly, an annuity contract that has an owner and annuitant who are different people is a “complex annuity” and comes with a host of problems you likely don’t want to deal with. The annuitant should be the same as the owner to avoid problems with benefit payments and taxes.

Once the contract owner chooses to take money out of the contract, those distributions are subject in part to income taxation.[11] In addition, distributions before the contract owner attains age 59½ are subject to a 10% tax penalty.

If you’ve made it through this article, congratulations! By now, your head may be spinning with all the rules, regulations, and strings attached to retirement accounts and benefits. Having a competent CDFA® who’s skilled in explaining complex rules on your divorce team may be exactly what you need.

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[1] For example, if you earn $80,000 annually from employment and take a $30,000 distribution (and are under age 59½), you pay $3,000 in penalties and $7,200 in taxes, which makes your $30,000 account magically shrink to $19,800. Your top marginal tax rate also jumped from 22% to 24%. 

[2] Before choosing to rollover 401(k) assets, make sure you have researched all of your options.

[3] A Required Minimum Distribution is arrived at using an IRS-provided formula. It is the amount you must take out of your account to avoid a 50% penalty tax on the undistributed funds.

[4] In some cases, you may have the option to take a lump-sum distribution as a rollover. Consider carefully the consequences of doing so, because you’ll be giving up guaranteed income for that lump-sum payment. A qualified CDFA® professional can help you sort through both scenarios and make an informed choice.

[5] If you choose to take benefits at your spouse’s early retirement age, those benefits may be reduced. Consider carefully if taking benefits early could hurt you down the road – another good reason to have a CDFA® on your team.

[6] The IRA Custodian will typically require you to open an IRA with them so that there is an account in your name to receive the assets awarded to you.

[7] Once you attain age 72, if you haven’t already begun making account distributions, you will be required to take Required Minimum Distributions each year.

[8] Once you attain age 72, if you haven’t already begun making account distributions, you will be required to take Required Minimum Distributions each year.

[9] There are some circumstances under which Roth IRA distributions can be subject to taxation: 1) you are under age 59½ in the year of distribution, or 2) the Roth IRA is less than five years old.

[10] These may be living benefits (benefits received during the life of the annuitant) or death benefits (benefits received at the death of the annuitant).

[11] A portion of each distribution is considered a return of principal and thus not taxable. Fully addressing this element is beyond the scope of this article.

Special thanks to Chris Dolen, MBA, CFP®, Senior Financial Planner here at Baird for his assistance in fact checking this article.