For many people, retirement plan assets make up a meaningful portion of their financial wealth. In a divorce proceeding, retirement plans often present additional challenges to an already difficult process.
Most states treat retirement plan assets as marital property. Therefore, unless you’re operating under a prenuptial agreement, you’re legally entitled to a portion of your spouse’s employer-sponsored retirement plan benefits, and vice versa. Since retirement plans can be of significant value and often come with important tax implications, it’s critical to understand how they are divided in a divorce so that your interests are protected.
I sat down with Casimira Pittman, CPA, senior management at Smith and Howard, to find out more about the division of retirement plan assets in a divorce. She shared the following information with me, to help explain how retirement plan assets are divided in a divorce.
Qualified Domestic Relations Order (QDRO)
According to the IRS, a Qualified Domestic Relations Order (QDRO) is a judgment, decree or order for a retirement plan to pay child support, alimony or marital property rights to a spouse, former spouse, child or other dependent of a participant. If you receive QDRO benefits from a retirement plan, you are required to report the payments as if you are a plan participant as well as receive a proportionate share of the account basis. In addition, as a former spouse of the employed participant, you can roll over any payments from the plan into another retirement account—for example, an individual retirement account (IRA).
A QDRO is designed to allow you to receive the benefits to which you’re legally entitled. Although your divorce settlement may say you have rights to a portion of your spouse’s retirement plan, the distribution must be done pursuant to a QDRO so as not to disqualify the plan for assigning benefits to a person other than the plan participant. It’s important to note that QDROs only apply to qualified retirement plans that are covered by the Employee Retirement Income Security Act (ERISA), such as defined contribution and defined benefit plans. QDRO’s cannot be used to split IRA assets, however IRA’s can be split under the divorce or separation agreement.
Defined Contribution Plans
A 401(k) is the most common example of a defined contribution plan. Determining the value of a defined contribution plan is relatively straightforward since it has a daily cash value, or balance. A defined contribution plan can be divided however the court deems appropriate with a QDRO.
If you receive payments as an ex-spouse from a 401(k) or other defined contribution plan, typically, you can roll them over to a retirement account without incurring any tax consequences. However, you’re not required to transfer the assets to another retirement account. While most retirement plan distributions prior to age 59 ½ are subject to a 10% penalty tax, distributions made to a former spouse pursuant to a QDRO are generally exempt from this penalty. Still, you’ll have to pay ordinary income taxes on any payments you receive if you choose to spend them.
Defined Benefit Plans
A pension is the primary example of a defined benefit plan. A defined benefit plan tends to be harder to value since instead of having a cash value today, it promises to pay the participating employee a set amount each month at retirement. In addition, any benefits accumulated before marriage or after divorce typically aren’t considered marital property. Therefore, if your spouse has a pension, determining your share of the benefits can be complicated.
Like a defined contribution plan, a defined benefit plan can be divided however the court deems appropriate with a QDRO. In general, three common methods are used to divide pension assets:
Present value/cash out method, in which the ex-spouse receives a lump sum settlement;
Deferred division method, in which no present value is determined, and each spouse is granted a share of benefits if and when they are paid by the plan;
Reserved jurisdiction, in which the court retains the authority to order distributions at some point in the future.
Finally, it’s essential to work with the pension plan administrator to set up survivor benefits. In the event your former spouse dies prior to retirement, you can preserve your rights to receive survivor benefits with a QDRO.
Individual Retirement Accounts (IRAs)
Compared to employer-sponsored qualified retirement plans, IRA assets are much simpler to divide in a divorce. Once the court determines each spouse’s share, you can roll over any payments you receive from your ex-spouse’s IRA to another retirement account without penalty or tax consequences. Should you decide to spend the proceeds instead, you’ll be subject to ordinary income taxes and the 10% premature penalty on early withdrawals will apply.
Dividing retirement plan assets in a divorce can be a complex and lengthy process. While understanding your rights beforehand can ease some anxiety, it’s often best to work with your legal, tax, and financial advisors to ensure an equitable division of assets. Your advisors can also help you implement the court’s decision in a tax-efficient and financially beneficial manner.