Retirement funds are often among the most valuable assets a divorcing couple owns, although before retirement they are often not given a whole lot of thought. How they are treated is one of the most important considerations to be dealt with in a divorce case, and in order to do that, the rules of the road need to be understood by both attorney and client. How such funds are distributed may be one of the most consequential decisions to be made in the divorce process, and there is a lot to know.
Understand the Different Types of Retirement Accounts that are Considered in a Divorce
In order to know what to do with retirement assets, it is important to first understand what it is that you, or your spouse, own. Basically, there are two styles of retirement plan: the defined benefit plan, which guarantees the owner an income stream in a predetermined amount each month, starting from a fixed age through the end of the pensioner’s life; and the defined contribution plan, which has a fixed value at any given point in time, just like a bank or brokerage account. Defined contribution plans are usually in one of two forms: the 401(k) account, which is funded by withholdings from an employee’s paycheck and contributions from his or her employer; and the Individual Retirement Account (“IRA”), which is either funded with a worker’s savings, “rolled over” from a 401(k) with a prior employer, or both. There may be multiple accounts if the person has had multiple employers. A person going through a divorce needs to be certain to know how many accounts they and their spouse have, and what kinds of accounts they are.
Taxes on Retirement Accounts are Deferred
The single feature of a retirement account that distinguishes it from other marital assets is that income taxes on the money which is contributed to a retirement account are deferred until the time that the money is withdrawn from the account. When an employee has money contributed from their paycheck into a retirement account, or makes a contribution to an IRA, they do not pay any income taxes on that money, and can thus reduce the total amount of income taxes paid in a given year by participating in an employer-sponsored plan, or putting money in an IRA. Because of this, it is of critical importance that when assessing the value of the account, its value be reduced by the estimated income taxes that will have to be paid on the funds when they are withdrawn, through the application of a tax factor. (The tax factor will vary depending upon what income tax bracket is expected to apply when the funds are withdrawn.) Your attorney will guide you in this process.
The same exercise needs to be engaged in with respect to a defined benefit plan, except that another step is involved: not only must the tax factor be determined and applied to reduce the value, but a “present value,” which takes into account the time value of money that is to be paid at a future date, based upon the employee’s earned monthly benefit, needs to be arrived at, which requires the services of an actuary. Your attorney should know who to contact should this service be needed in your divorce.
And why is this so important? Because when measuring which assets are to be retained by each spouse, apples need to be compared to apples, and a pretax 401(k) account with a balance of $500,000 is worth considerably less than an ordinary savings account with the same balance, because income taxes have already been paid on the savings account.
Premarital Retirement Contributions Are Retained by the Owner
In addition to determining the value of an account for divorce purposes, if a spouse made contributions to the account, (or earned rights to a pension), before the marriage, those amounts remain with the spouse who earned them. All premarital contributions to a retirement account, (as well as any made after a divorce is underway), as well as the interest or earnings on that premarital portion, need to be determined and deducted from the account value in order for the amount eligible for distribution on divorce to be arrived at. This is because only monies earned during the marriage are subject to equitable distribution. This calculation can be somewhat complicated, and your attorney should assist with getting the number right.
How Retirement Accounts Get Divided in a Divorce
Once the values of the assets at issue in are determined, they need to be measured against the value of other assets, so that a fair division can be arrived at. And it is at this point that important decisions need to be made. One such decision is whether to divide or to offset.
If a divorcing couple has two primary assets, a $500,000 residence, (net of any mortgages), and a 401(k) with a value of $500,000 after consideration of the tax factor, one possibility would be to sell the home and share the proceeds, and to divide the retirement account. But if the residence is serving as a home to younger children, whose lives are already being disrupted due to divorce, it may be more sensible for the custodial parent to retain the home and the other parent to retain the retirement account. This is an example of a direct offset. This is a decision for the divorcing spouses to make, and there are endless possible variations, which can take into consideration a spouse’s retention of other assets, or any other credits the parties agree to.
If a retirement plan interest is to be divided, it must be done in a way that avoids the unintended incurrence of income taxes and penalties for early withdrawal. As a general rule, under Federal law, an interest in a qualified retirement plan cannot be transferred from one person to another, and money in an IRA cannot be transferred, without the immediate incurrence of income tax on the amount transferred by the person whose name appears on the account. However, an exception is made for divorcing spouses, who can transfer and/or divide the funds in retirement accounts tax free upon divorce, so long as the division conforms to special rules concerning such transfers. With defined benefit plan interests and 401(k)s, this is accomplished with a Qualified Domestic Relations Order, or QDRO, a special form of court order meeting the requirements of the Internal Revenue Code and the federal Employee Retirement Income Security Act, also known as ERISA. A QDRO allows for the funds in a retirement plan to be transferred as part of a divorce without the incurrence of income taxes or penalties. Spouses are free to determine, by amount or percentage, how the funds in such an account are to be allocated between them, whether the retirement plan is a defined benefit, in which case the funds will be received as part of an income stream as provided for in the retirement plan, or a cash balance plan, under which the funds would be available to the non-employed spouse following divorce. Your attorney will be responsible for seeing to it that this complicated process is carried out correctly.
With an IRA, the process is much simpler. While you cannot withdraw funds from an IRA without incurring income taxes, and a penalty if the funds are withdrawn before age 59.5, federal law does allow for a tax-free IRA “rollover” incident to divorce. Unlike the situation with the QDRO, here, no special documentation is required; there simply needs to be a second IRA in the name of the receiving spouse to which the funds can be transferred, and an awareness on the part of the financial institution making the transfer that it is a tax free rollover that is part of a divorce. The bank or other financial institution may ask to see a divorce judgment or settlement agreement to be certain that there is in fact a divorce.
When Contemplating a Divorce, and Splitting Retirement Assets, Get Good Advice
Like so many other aspects of the divorce process, you will hopefully be dealing with these issues only once in your life, and knowing your options and getting them right is important, as there will not be a do over if you later learn something that you did not know before your divorce process has concluded. There is much more to know about the ins and outs of retirement plan interests in divorce than this short piece can include, and having representation from a professional who not only knows the right answers but asks the right questions is critical to the outcome of your divorce. And while many capable attorneys who work as general practitioners handle divorces, the fact is that the number one area for malpractice cases against attorneys handling divorces is missteps concerning retirement plan assets, where a small mistake can be very costly to the client. On the whole, this is not simple stuff.
If there are retirement assets to be allocated in your divorce, be sure that your attorney has the necessary level of knowledge and experience to insure that all options are made known to you, and that the process will be executed correctly.
Do you have questions about how to divide retirement assets during a divorce?
Patrick T. Collins is a Divorce Attorney at Skoloff & Wolfe, P.C.