Divorce: Dividing Retirement Assets

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There are certain times in life when you are faced with a lot of important financial decisions over a short period of time, with which you may have never previously dealt. During a divorce is one of those times.

The situation is made even more complicated due to the fact that most people have the bulk of their financial wealth (aside from their home) tied up in their retirement assets – i.e., their 401(k) and IRA’s, both of which are subject to a slew of their own particular technical rules.

This can create a minefield of traps for the unwary.

Regarding your 401(k) plan, it is typically held by an administrator such as Vanguard, Fidelity, etc. Each of the divorcing spouses will be entitled to half of the 401(k) value that accumulated during the time of marriage.
The 401(k) is split by using what’s called a QDRO, or “Qualified Domestic Relations Order.”

This is an order issued by the court that is sent to the plan administrator, ordering the 401(k) to be split according to the interests of each spouse. The calculation of each spouse’s share can be quite complex and it’s absolutely critical to consult with a specialist in these situations. After the split is complete, the non-401(k) owner spouse will typically move their share to their own IRA account, at which point each spouse can begin making their own separate financial planning decisions.

Note that this is typically a tax-free transaction, with the accounts remaining tax-deferred until the spouses take distributions in the future; typically many years later when they are retired.

There is a special tax “loophole” that can potentially be extremely valuable in this situation. Normally, any distribution taken from a retirement account before age 59-1/2 is subject not only to tax, but also a 10% premature distribution penalty.

However, in cases where a spouse moves money from their ex’s 401(k) to their own IRA, they have the option of rolling only a portion of it into their IRA, and taking a penalty-free distribution for the rest. Let’s say they need some extra cash in order to pay attorney’s fees, or to make a down payment on a new residence; this loophole allows them to access some money from the retirement funds without paying any penalty.

The distribution will still be subject to ordinary tax, but in many cases they will be in a lower tax bracket in the year of divorce, especially if they are the lower-earning spouse. So, this particular tax loophole could come
in very handy indeed.

When it comes to IRAs, there are still more rules to keep in mind.
An IRA is split in accordance with the divorce decree, which is different from a QDRO. The IRA owner typically will instruct their IRA custodian to make the split in accordance with the divorce decree. One critical mistake made by many IRA owners in this situation is to just ask for a check from their IRA custodian, which they deposit into the bank, and then they write a separate check to their spouse for his or her share of the IRA.

If it’s done this way the IRS will treat it as a distribution, which will be taxable to the IRA owner, along with a 10% penalty if they are under age 59-1/2. This has happened over and over again and tax court cases have consistently held in favor of the IRS in these situations.

The better solution is to do what’s called a trustee-to-trustee transfer. This means that the non-IRA owner finds their own custodian to hold their IRA, sets up their account, and then the funds are transferred directly from one IRA custodian to the other. If it’s done this way there is no immediate tax to either spouse, and the funds remain tax deferred until a distribution is taken in the future.

These are just a few of the complex rules that govern how to split retirement assets in divorce–as you can see, it’s certainly not something
to take lightly.

If you know anyone facing this situation, it’s critically important that they get accurate and fair advice on how to proceed. Feel free to contact me if you would like any further details or have any questions.