What Happens To My Retirement Account After a Divorce?
Retirement accounts are one of the most divided assets in any divorce proceeding. Whether you have a qualified plan such as a 401(k) or a non-qualified plan such as an IRA, it is imperative to understand how to effectively use these assets to obtain an equitable division of property and maintain adequate funds to finance your retirement.
Because retirement plans are tax deferred savings vehicles, Congress has sought to deter people from accessing the funds in these accounts prior to retirement. However, retirement plans are considered marital property and are subject to division at divorce. As such, Congress has relaxed the transfer and distribution rules pertaining to retirement accounts when the transfer occurs within a divorce.
Retirement accounts come in two forms: Qualified and Non-Qualified. Qualified plans include 401(k), 403(b), and Pension Plans. Non-Qualified plans include Traditional and ROTH IRAs. The best plan of disposition for your retirement account pursuant to a divorce depends on the type of account you own, each party’s retirement savings goals, and your former spouse’s cash flow needs.
Qualified Plans: 401(k)
If your 401(k) plan is divided during a divorce, the most commonly used option for transferring funds is a "qualified domestic relation order" or QDRO (Pronounced Quad-row).
A QDRO assigns to an ‘alternate payee’ (your former spouse) the right to receive, all or a portion of the benefits payable to the ‘participant’ (you) under a retirement plan. A QDRO does not create a new 401(k) for your former spouse. Instead, a QDRO is merely a court order permitting the transfer and distribution of account funds to the ‘non-participant spouse.’
In the event of a QDRO, the participant is not taxed or penalized for the assignment or distribution of the funds. The non-participant spouse then has the burden of determining how to dispose of the funds received through the QDRO. The non-participant spouse usually has four options.
Option #1: Leave the Funds in the Participant’s 401(k)
If the plan is administered well and has been producing sufficient returns, they non-participant spouse may want to leave the funds allocated to him or her in the participant spouse’s 401(k) plan. It is always advisable to consult with the plan administrator to ensure that this option is available to a non-participant spouse. Also, the non-participant spouse may then be subject to the same vesting requirements as the participant spouse and the funds may be harder to access in the short term. This option is not advisable for a non-participant spouse concerned about present cash flow.
Option #2: Direct Rollover To Non-Participant Spouse’s Individual IRA
If the non-participant spouse is not in immediate need of cash, but does not want to keep the allocated funds in the Participant spouse’s 401(k) plan, the non-participant spouse can rollover the funds to a personal IRA.
There is a large difference between “rolling over” and “transferring money” from a Qualified Plan to a Non-Qualified Plan. A rollover is a direct custodian to custodian exchange of funds from the administrator of the 401(k) to the administrator of the IRA. In a rollover, the non-participant spouse never actually receives the funds. Instead, the funds are rolled over directly from one plan to another.
In a “transfer” the 401(k) administrator will cut a check to the non-participant spouse and the non-participant spouse will be responsible for placing the funds in another Qualified or Non-Qualified plan within 60 days. There are two potential tax pitfalls in the “transfer” option. First, because the non-participant spouse will receive the funds personally, the funds are immediately subject to a 20% withholding tax. Second, if the non-participant spouse does not add that 20% back in when the funds are transferred to the IRA and make the transfer to the IRA within 60 days, the entire distribution amount will be subject to income tax as well as a 10% penalty if the non-participant spouse is under age 59 ½ .
Option #3: Take a Lump Sum Distribution Prior to Rollover
This option is the best option for a non-participant spouse in need of immediate cash flow, but who also wants to keep part of the funds protected in a retirement plan. Internal Revenue Code § 72(t) permits an alternate payee to take a cash distribution from the allocated 401(k) funds prior to rolling the funds over to an individual IRA. The non-participant spouse won't receive the 10% penalty for taking the cash distribution, but will be taxed on the amount requested as cash and 20% federal withholding will be deducted before the distribution is made.
Option #4: Cash Out
This option is only recommended for a non-participant spouse in need of immediate cash flow and over the age of 59 ½. Instead of rolling over any amount of the allocated 401(k) funds, the non-participant spouse can simply cash out the funds. Regardless of the age of the non-participant spouse, the funds will always be subject to a 20% withholding tax and income tax. However, if the non-participant spouse is under age 59 ½ the distribution amount will be subject to a 10% penalty.
If you have a non-qualified plan such as an IRA and your retirement asset is divided during a divorce, there are two basic disposition options available to you and your former spouse.
Pursuant to I.R.C. §408(d)(6) if an interest in a traditional IRA is transferred from you to your former spouse by a divorce or separate maintenance decree or a written document related to such a decree, the transfer is tax free.
There are two commonly-used methods of transferring IRA assets to a former spouse. The methods are: Changing the name on the IRA and making a direct transfer of IRA assets.
If all the assets are to be transferred, you can make the transfer simply by changing the name on the IRA from your name to the name of your former spouse.
Under the ‘Direct Transfer’ method, you direct the trustee
of the traditional IRA to transfer the affected assets directly to the
trustee of a new or existing traditional IRA set up in the name of your
former spouse. If your former spouse is allowed to keep his or her portion
of the IRA assets in your existing IRA, you can direct the trustee to
transfer the assets you are permitted to keep directly to a new or existing
traditional IRA set up in your name. The name on the IRA containing your
former spouse's portion of the assets would then be changed to show
his or her ownership.
The division of retirement assets in the context of divorce can seem overwhelming and cumbersome. However, it is important to involve your financial planner or CPA in the decision making process. More likely than not, an equitable solution can be found to meet each party’s present and future retirement needs.