Divorce and 401Ks and IRAs
Funding retirement is one of the hottest topics there is in personal finance today. Add a divorce to the mix, and the discussion about retirement accounts between separating spouses becomes even more emotional and confusing.
It is always hard to separate assets. In truth, both parties end up with less than what they had together, and it is hard to feel safe and OK. Adjusting to a new financial and emotional situation takes courage and acceptance and a willingness to let go of the struggle.
Let’s start by reviewing the three main types of retirement funding that exist today:
- Defined-benefit pensions in which the person’s employer funds the whole thing. This promises the employee a specified monthly benefit at retirement. The employee has no say in the amount invested or paid. Please see my post, “Anything But My Pension,” for details on how pensions are handled in divorce.
- Defined-contribution plans. These include 401(k), 403(b), and 457 plans. In these plans, the employer does not promise a specific amount of benefits at retirement. The employee or the employer (or both) contribute to the employee’s individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually. These contributions are invested on the employee’s behalf. The employee has control of the how the money is invested. However, investment options are limited to those that have been made available within the fund.
- Individual Retirement Accounts (IRAs): These are opened by individuals and are not connected to any employer plan. There are 4 types: Traditional, Roth, SEP, and SIMPLE. To make things more confusing, the law does allow employers to make contributions to some of these plans.
It’s important to have a list of all retirement-related accounts owned by you and your spouse to work with during the divorce process. The list should indicate the type of account and the current balance. If you are not sure of either, contact your employer or the financial planner that set up your accounts to get this information.
Let’s look at each of the last two types of retirement accounts in more detail.
Divorce and the Defined Contribution Retirement Plan
An employee contribution retirement fund islso called a deferred compensation plan. For simplicity in this post, I use “401k” to refer to the main plans in this type:
- A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account. You control how your money is invested. Most plans offer a range of mutual funds composed of stocks, bonds, and money market investments. There are complex rules about when you can withdraw your money and costly penalties for pulling funds out before retirement age.
- A 403(b) plan is a retirement plan for certain public school employees, employees of tax-exempt organizations and ministers. Individual 403(b) accounts are established and maintained by eligible employees. The employer may determine the financial institution(s) at which individual employees may maintain their 403(b) accounts, which in turn determines the type of 403(b) accounts that the employees may establish and fund.
- The 457 plan is a type of non-qualified, tax-advantaged deferred compensation retirement plan that is available for governmental and certain non-governmental employers. The employer provides the plan and the employee puts part of his or her earnings into it on a pre-tax basis.
Divorce and the Individual Retirement Account (IRA)
An IRA is an account set up at a financial institution that allows an individual to save for retirement with tax-free growth or on a tax-deferred basis. The three main types of IRAs each have different advantages:
- Traditional IRA: You make contributions with money you may be able to deduct on your tax return. Any earnings can potentially grow tax-deferred until you withdraw them in retirement. Many retirees also find themselves in a lower tax bracket than they were in pre-retirement, so the tax-deferral means the money may be taxed at a lower rate when it is withdrawn.
- Roth IRA: You make contributions with money you’ve already paid taxes on (after-tax). Your money may potentially grow tax-free, with tax-free withdrawals in retirement, provided that certain conditions are met.
- Rollover IRA: A Traditional IRA intended for money “rolled over” from a qualified retirement plan. Rollovers involve moving eligible assets from an employer-sponsored plan, such as a 401(k) or 403(b), into an IRA.
Sharing a 401(k)-Type Plan or IRA Through Divorce
Both 401Ks and IRAs have rules and regulations regarding the maximum annual contribution and under what terms you can withdraw funds. The key points are:
- There are penalties for withdrawing retirement funds prior to age 59-1/2.
- These funds are generally invested in stocks and mutual funds so they are subject to the volatility of the financial markets.
The method required to share a 401K versus an IRA during a divorce has some special (but not complicated) considerations. First and foremost, regardless of whether you are over or under age 59-1/2, do not withdraw retirement funds directly and give the funds to your spouse. The distribution needs to be part of the divorce decree to avoid unanticipated taxes and penalties.
Sharing a 401K-Type Plan
Let’s use a fictional divorcing couple as an example. Ellen has a 401k of $30,000 and Jeff has a 401k with $70,000. They want to share the total assets of the 401ks equally between them. The total is $100,000, and 50% is $50,000.
Because Ellen already has $30,000 in her 401k, she would be owed $20,000 from Jeff’s account. Then she would keep 100% of her own account.
If the distribution is processed through a QDRO (see below), the following applies:
- There are no taxes or penalties to Jeff, the owner of the 401K from which funds are being taken to give to Ellen.
- Ellen has the option to put her share of Jeff’s 401K into a tax-deferred account such as an IRA. Then she will pay no taxes or penalties.
- Ellen also has the option to take some or all of her distribution in cash. Ellen will pay taxes but no early withdrawal penalties on the amount she takes in cash.
- The distribution of these funds can only take place after the Judgment of Divorce is signed.
- To process the distribution, a court document called a Qualified Domestic Relations Order (QDRO) must be signed by a judge. A QDRO (pronounced “kwa-dro”) is a legal document that tells your retirement account plan administrator how to divide the assets and that the division is pursuant to a divorce. As a QDRO is a legal document, there is typically a fee for a lawyer (or similarly trained professional) to create this document.
- The distribution of the funds lags several months following the divorce decree as the plan administrator of the 401K approves and processes the distribution.
- The option to take cash without penalties is a one-time only option and must be done before the funds are placed into another tax-deferred account.
- Taking cash without paying penalties is only an option when funds originate in a 401K-type investment. This is not an option when funds are taken from an IRA-type investment.
Sharing an IRA Plan Through Divorce
Using the same couple, Ellen and Jeff, let’s imagine that they both have IRAs in the same amounts listed above, and neither has a 401K plan. The math to calculate the sharing is the same; Ellen will receive $20,000. Here’s how the IRA sharing works:
- The distribution can only take place after a Judgment of Divorce.
- In virtually all cases, a QDRO is not needed to initiate the IRA distribution.
- The distribution commences upon the Authority of the Judgment of Divorce, usually within 30 days of the final divorce decree.
- Jeff would provide the divorce decree that indicates the distribution to the plan administrator. The funds would be transferred to Ellen’s IRA or Ellen can start a new IRA.
- If Ellen decides to take the $20,000 in cash instead of moving it into an IRA, she would also pay taxes and withdrawal penalties.
NOTE: If you have several old 401K plans from several previous employers, do not consolidate them into an IRA until after the divorce to preserve the option of taking penalty-free money.
Sharing a Roth IRA Through Divorce
Another type of individual retirement account is a Roth IRA. You fund these with money on which you have already paid income tax. When you are eligible to use the IRA’s funds (over age 59-1/2), you do not pay taxes on your withdrawals.
Using our same couple, Ellen and Jeff, let’s say Ellen’s $30,000 is in a Roth IRA, and Jeff’s $70,000 is a in pre-tax IRA account. That means Jeff’s account was built with money on which he paid no income taxes prior to putting it in the account.
When the amount in a Roth IRA is significant, then it is usually most equitable to split the Roth IRA separately from distributing the 401K funds. Sharing the funds in this manner eliminates the need to calculate the taxed versus pre-tax dollars. The Roth IRA does not require a QDRO; the 401K would require one even if Ellen and Jeff chhose to equalize the accounts by sharing some of the 401K. If they prefer to share the 401K funds, it requires equalizing the taxes between the accounts prior to the distribution.
Retirement Accounts and Divorce
There are strategies and creative options as to why parties agree to distribute funds from one to the other. For example, it is a good way to free up cash if it is needed to pay off marital debt or fund the down payment on a new home, especially if the receiver is the lower income party.
As you can see, this is a complicated financial situation. Your divorce mediator and financial professional can help both of you sort through it.
Divorce and Retirement Account Resources
- “What Is a 401(k) Retirement Plan?“
- “403(b) Plan Tutorial“
- “What’s a 457 Plan?“
- “QDRO’s – An Overview and FAQs“
Photo credit: © (c) Can Stock Photo / karenr
This blog and its materials have been prepared by BJ Mediation Services for informational purposes only and are not intended to be, are not, and should not be regarded as, legal or financial advice. Internet subscribers and online readers should not act upon this information without seeking professional counsel.