Can you divide retirement accounts in divorce without suffering tax penalties?
Dear Client and Friends,
There is a common perception that divorcing spouses must liquidate retirement accounts for the purpose of splitting up property, and consequently accept the tax consequences for early withdrawal. This would rob account owners of the tax advantages that make things like individual retirement account (IRAs), 401(k)s and other accounts popular vehicles for retirement savings in the first place.
But don’t assume this is the case.
Because of the penalties, as well as restrictions on the transfer of accounts from one living person to another, laws have been passed that allow for certain retirement accounts to be divided at divorce without tax penalties.
For example, an IRA can be divided by executing what’s called a “transfer incident.” If under the terms of your divorce agreement you plan to split your IRA 50/50 with your now-ex-wife, she will still pay tax on any distributions she takes after receiving the funds, which means she may try to negotiate a bigger split to account for that. But you won’t be taxed on the assets sent to her if you properly identify and execute the transaction as a transfer incident. That’s why it’s so important to consult with a divorce lawyer who understands these things and can make sure this is done properly.
Other types of retirement accounts, like pensions, 401(k)s and 403(b)s, can be divided without tax consequences via a qualified domestic relations order (QDRO).
The court overseeing your divorce issues the order to split the account. But the wording of the order has to be approved by the entity that handles the account. For example, if you’re a government employee, such as a teacher, a state worker or a member of the military, the plan must be approved by the government department that handles your retirement account. If you work in the private sector, the plan administrator (the financial institution handling the account) has to give its approval. Approval is typically granted if the order complies with rules and regulations on the division of retirement funds.
So what are the mechanics of the payments once an account is divided through a QDRO? That depends on the type of plan. Some plans, such as pension plans, make payments to a retired person in monthly installments. In this case, a QDRO will often call for payments to be split between the account holder and his or her ex-spouse based on how much of the marriage coincided with the years the pension was earned.
For example, if a couple marries and divorces within a few years of the account owner’s retirement, his or her spouse wouldn’t be entitled to as generous a split of future payments as they would be if they had been married for the owner’s entire working life prior to divorce. Similarly, if a couple divorced just a couple of years after the owner started contributing to the account, the QDRO likely would not give the other spouse the right to collect much of the currently unvested payments in the future.
But what if the account provides for a lump sum payment upon retirement, as with a 401(k) or its public-sector version, a 403(b)? In such a case, the court might order that the account owner retain his or her share of the account while ordering a different tax-deferred account created for the other spouse. The transfer of assets into the new account wouldn’t result in taxes or penalties, but the recipient spouse would still want to consult with a professional on how to handle the funds going forward.
Does any of this sound confusing? If so, that’s OK, because this is complicated stuff, and there are other things to consider, like whether it’s more advantageous for the receiving spouse to take a lump-sum division in cash or roll it into an IRA of his or her own. It’s certainly worth getting in touch with us to explain these matters in more detail and decide what options work for you and we continue to provide a free phone evaluation for you and yours.