Valuing and dividing retirement accounts is more complex than most divorcing couples expect. Below are five common questions we receive regarding divorce and retirement accounts.
Imagine that only one spouse worked for most of the marriage while the other cared for the kids. If that's the case, most of the retirement assets are likely only in one spouse's name. It is common for clients who own retirement accounts to believe that they are entitled to the entire account since it's in their name. However, money earned during the marriage is a marital asset and subject to division in a divorce.
In contrast, retirement assets earned prior to the marriage are typically considered separate assets and not subject to division in the divorce. In addition, the growth on those separate assets during the marriage is considered separate property. For an accurate appraisal of what portion of a retirement account is separate versus what portion is marital, we can provide you with a separate property tracing. The burden of proof is on the person making the separate property claim.
You are not necessarily taxed on the division of retirement accounts. Each plan or account has different requirements to divide it tax-free. For example, a qualified retirement plan such as a 401-K governed by the Employee Retirement Income Security Act (ERISA) will require a Qualified Domestic Relations Order (QDRO) to divide the investments in the account.
Other retirement plans, such as many traditional IRAs or Roth IRAs, may not require a QDRO. Many of these plans require a copy of the divorce decree and custodian-specific forms to divide the account. Contact the custodian if you are not sure what is required.
Retirement assets are only one part of the marital estate. In a divorce, there are many decisions to be made regarding each of the assets involved. Keep in mind that liquidity is key to starting over financially.
Pension plans typically rate lowest on the list of assets to obtain because those funds are not liquid today (unless you are at retirement age). Further, each plan has its own rules surrounding availability of the pension funds to the ex-spouse. It’s wise to know the rules of each pension plan before you sign any binding documents.
IRA’s typically rank lowest on the scale of available, liquid assets because withdrawals are usually taxed at the owner’s highest marginal tax rate and incur a 10 percent penalty until age 59.5 (although there are exceptions).
ERISA regulated plans (such as 401k’s) are one step above the Traditional IRA regarding assets available for liquidity as you can redeem cash from your ex-spouses 401k plan without paying the 10% penalty, but you still must pay taxes. There is also a federally mandated 20% withholding on all cash distributions. For example, if you want $80,000 in cash from your ex-spouses 401k, you’ll need to withdrawal $100,000 as 20% ($20,000 in this example) will automatically be forwarded to the IRS. Lastly, 401k’s follow QDRO rules and it takes time for the QDROs to finalize.
ROTH IRA’s are the most advantageous retirement asset for liquidity needs during or after divorce. The principal put into a ROTH IRA can be withdrawn, separately from the growth or earnings, tax and penalty-free. The earnings on the ROTH IRA will likely be subject to taxation and the 10% early withdrawal penalty (before age 59.5). ROTH IRA’s have other quirky rules regarding a 5-year timeline. Check with your CPA on the specific rules surrounding your situation.
Non-retirement assets are generally better to obtain than retirement assets in a divorce. Brokerage accounts will typically have some amount of principal which is already taxed, and the earnings may be taxed at a lower capital gain rate.
What about the house? The home sale proceeds nearly always rank high on the list of desirable assets. A large share of gain from the sale of a primary residence (after closing costs are paid) is not taxed and, unlike most retirement plans, these proceeds are available to divorcing clients before age 59.5 without penalty.
Cash savings and checking accounts are, obviously, the most liquid.
When the receiving spouse is awarded a share of a qualified plan like a 401-k, the share is most often moved to an alternate payee account inside the plan. Under IRS rule 72(t)(2)(C), the alternate payee can make an early withdrawal without the 10 percent penalty. Ordinary income taxes will still need to be paid. For a spouse with little or no income in the first year of divorce, this can be a source of liquidity to support his or her lifestyle.
The plan administrator will withhold 20 percent because the alternate payee will be required to pay marginal taxes on any withdrawal. The more the spouse withdraws, the higher the taxes owed.
The alternate payee does not need to withdrawal the full amount awarded in their divorce. Rather, s/he can let the plan administrator know how much cash should be distributed and what to with the balance (e.g. roll it into an IRA to avoid additional taxation).
Many attorneys will “tax effect” retirement plans (discounting the account by the recipient’s highest marginal tax rate). Left unchecked, the spouse receiving more of the retirement accounts may benefit (possibly unfairly) in negotiations from this practice.
In order to properly “tax effect” each account, the parties need to know when and how much will be withdrawn as well as future tax rates for each party. We know nobody has a crystal ball to know future tax rates, Thus, we use the information available to us today to make those assumptions.
By preparing financial projections, a CDFA professional can assess the amount and timing of the recipient’s anticipated withdrawals from retirement accounts.
Retirement accounts are complicated, especially in divorce. Understanding tax implications and liquidity are critical in divorce negotiations. Ensure you are receiving the settlement that’s best for you by having the right people on your team.