According to CNBC, high-net-worth households hold over half their wealth in IRAS and 401(k)s. Given the prevalence of retirement accounts, it is vital to understand them so you can reach a settlement that meets your short-term and long-term needs.
But retirement accounts and benefits are often the assets that are least intuitive, the most complex, and have the most strings attached.
While the topic is complex, it’s not impossible to unravel.
This month I’m outlining the most common retirement accounts and benefits you’ll see in a divorce and helping you build a basic understanding so you can feel confident about your settlement.
Framework for Understanding Retirement Accounts
Before we get into the details of each retirement account and benefit type, I want to build a framework for you to understand them.
A retirement plan or benefit can be a Defined Benefit Plan (the plan sponsor promises a specific benefit at a future date), or a Defined Contribution Plan (the plan sponsor promises a specific contribution but does not guarantee a particular future benefit).
A plan’s status as either Defined Benefit or Defined Contribution will factor in to how it is valued on your Inventory of Assets and Debts and will also factor in on how desirable the asset is to you.
A retirement plan or benefit can be employer-sponsored (tied to your or your spouse’s employer) or individual (tied to an individual only).
Finally, a retirement plan or benefit can be Qualified or Non-Qualified. A Qualified Plan meets the IRS requirements to be considered Qualified. A Non-Qualified Plan does not.
A plan’s status as Qualified or Non-Qualified will determine the mechanics of how it is divided after the divorce is finalized.
Qualified Plans are divided using a Qualified Domestic Relations Order. Non-Qualified Plans are divided using a Letters of Instruction and / or forms provided by the firm holding the assets.
Now that we have a way to classify these plans in our minds, let’s look at some specific types.
401(k), 403(b), & Thrift Savings Plans
What is it?
401(k) plans and their lesser-known cousins, the 403(b) and Thrift Savings plans, are common. They are employer-sponsored Defined Contribution Plans and falls into the Qualified Plan category. The employee and employer typically make monthly or yearly cash contributions.
Read: 401(k) Basics
The plan does not guarantee that the account will have any specific value in the future. The money contributed to the plan is invested at the direction of the plan participant (you or your spouse).
You can determine the value of the plan simply by reviewing a recent account statement. The value of the plan is equal to the Vested Balance.[1]
What you need to know
401(k), 403(b), and Thrift Savings Plans are divided using a Qualified Domestic Relations Order (QDRO) because they are Qualified Plans.
This document is separate from your Divorce Decree. It could take weeks to draft and months to be processed by the courts and the plan sponsor (the employer).
Dividing a 401(k) (or similar plan) using a QDRO is a non-taxable event.
Read: What is a QDRO?
Once the QDRO has been processed, the employer sponsoring the plan will open a plan account for the person receiving funds from the plan.
“Dividing a 401(k) using a QDRO is a non-taxable event.”
The receiving spouse is referred to as the alternate payee. Once the alternate payee account is created and funded, there are three options for what an alternate payee can do with the money:
- Take a lump-sum distribution: Taking a lump-sum distribution is almost always a bad idea. Doing so will make the entire account balance subject to income taxation in the year of distribution. And, if you have not attained age 59½, you will be subject to an additional 10% tax penalty. This destroys wealth and can bump you into a higher marginal tax bracket since the entire distribution is treated like the income you earn from working.
- Leave the assets in the account: This can be a great option if you don’t need the money right now and don’t have a compelling reason to roll over the assets to a Rollover IRA or your own Qualified Plan (e.g. your 401(k), 403(b), or Thrift Savings).
- Rollover your assets to your own Qualified Plan: If you have your own Qualified Plan at work (e.g. 401(k), 403(b), or Thrift Savings), and if that plan accepts incoming rollovers, you can elect to roll over to your plan. This can be a great way to consolidate assets and simplify your life. A direct rollover has no tax consequences.
- Rollover your assets to a Rollover IRA: Some people choose to execute a direct rollover to a Rollover IRA to consolidate assets or access professional investment advice. A direct rollover transaction has no tax consequences.
Money held in a 401(k), 403(b), or Thrift Savings Plan can’t be distributed without penalty until you attain age 59½.
If you take money out before that time, you will be subject to a 10% penalty in addition to income taxes.
Once you reach age 73, if you haven’t started taking money out, the IRS will require you to begin taking Required Minimum Distributions.
There is a workaround for the 10% penalty if your QDRO is drafted properly. There are also limited exceptions to the penalty. This is a key reason to use a divorce financial expert like a Certified Divorce Financial Analyst™ in settlement negotiations.
If you need access to assets and the only thing on the table is a Qualified Plan like a 401(k), a CDFA® may recommend integrating a Rule 72(t) provision into your QDRO or using one of the exceptions permitted by the IRS.
Learn more: What is a CDFA®?
Pension
What is it?
A pension is an employer-sponsored Defined Benefit Plan and falls into the Qualified Plan category. The typical pension promises a stream of fixed payments (usually monthly) starting when the employee retires and ending with the employee’s death.
What you need to know
Valuing a pension is not always straightforward.
If the plan offers a Lump Sum payment option, you need only review the annual account statement to know what the plan is worth. But if the plan does not offer a Lump Sum payment option, you may need to have the value of the plan assessed by a professional, like a CDFA®.
If there is no Lump Sum payment option, and hiring an outside professional isn’t possible, you can elect to divide the pension benefit 50/50.
Like other Qualified Plans, pensions are divided using a Qualified Domestic Relations Order (QDRO). Also, as with other Qualified Plans, once a QDRO is fully processed, the employer sponsoring the plan will open a pension benefit account for the alternate payee.
There are two ways to write the QDRO used to divide a pension, and the method used for your case can have a big impact on your immediate and future financial health.
Shared Interest
A Shared Interest QDRO allows the alternate payee to receive benefits only when the participant begins receiving them. If you are the younger spouse and need the pension income to sustain yourself, you’ll have to wait until your ex-spouse starts taking their benefits.
Shared Interest QDROs are best for pensions already in pay status – where the participant is already receiving benefits.
Separate Interest
A Separate Interest QDRO allows the alternate payee to receive their share of the pension benefit at any time on or after the participant becomes entitled to receive their pension benefit.
If you are the younger spouse, you can start your benefit when your ex-spouse reaches the plan’s early or normal retirement age. In this case you are only waiting for your ex to age, not retire, before you can receive benefits.
Those benefits may be reduced if you choose to take benefits at your spouse’s early retirement age.
Taking benefits early could hurt you down the road – another good reason to have a CDFA® on your team.
Regardless of how your QDRO is written or when you take benefits, those benefits will be subject to income tax in the year received, just like a paycheck.
Individual Retirement Arrangement (IRA) Account
What is it?
An Individual Retirement Arrangement account, better known as an IRA, is a Defined Contribution Plan and falls in the Non-Qualified category. As with other Defined Contribution Plans, you can determine the value of the plan by reviewing a recent account statement.
IRAs come in a few different formats.
What you need to know
Regardless of the format, IRAs are generally divided using your Divorce Decree and a Letter of Instruction signed by the IRA owner and addressed to the financial institution where the IRA is held (often called the IRA Custodian).
Alternately, the IRA Custodian may ask you complete their own internal forms to divide an IRA. It’s wise to call the IRA Custodian to ask how their process works before you start.
Once your Divorce Decree has been entered with the court and a certified copy is available, the division process can take a few days or weeks.
Upon receipt of a certified copy of your Divorce Decree, Letter of Instruction (or internal forms), and signed account opening forms, the IRA Custodian will open a new IRA account with the new owner’s name on it and transfer the assets awarded into the new account.
Once the new IRA is funded, it is up to the new owner to determine how the funds in the account will be invested.
Now let’s dig into need-to-knows for each type of IRA:
Rollover IRA
This IRA is funded using the proceeds of an employer sponsored retirement plan Rollover. Because all the funds in the account are pre-tax dollars, all funds distributed from the account will be subject to income taxation in the year of distribution.
Like other retirement accounts, most distributions taken before you attain age 59½ will be subject to an 10% penalty in addition to income taxes.
Once you reach age 73, if you haven’t started taking money out, the IRS will require you to begin taking Required Minimum Distributions.
No matter when they are taken, distributions are subject to income tax in the year of distribution.
Traditional IRA
This IRA is funded with annual cash contributions from the IRA owner. Because some funds in the account may be post-tax, not every dollar distributed is automatically subject to taxation.
However, unless your ex-spouse kept their annual tax reporting (and you can access those reports), it may be difficult to prove the amount of post-tax dollars in the account.
Like other retirement accounts, most distributions taken before you attain age 59½ will be subject to an additional 10% penalty.
Once you reach age 73, if you haven’t started taking money out, the IRS will require you to begin taking Required Minimum Distributions.
No matter when they are taken, distributions are subject to income tax in the year they are taken.
Roth IRA
This IRA is funded with annual contributions of post-tax dollars from the IRA owner. A Roth IRA is special because normal distributions are not subject to income tax.
Like other retirement accounts, most distributions taken before you attain age 59½ will be subject to a 10% penalty.
In addition to not being subject to income tax, Roth IRAs are also no subject to Required Minimum Distributions. This makes Roth IRAs especially desirable in some divorce cases.
SEP IRA
This kind of IRA is a type of Non-Qualified employer-sponsored plan and is funded with cash contributions from the employer and employee. SEP IRAs are common for small businesses owners, employees of small businesses, and sole proprietors.
As with the other IRA types, most distributions taken before you attain age 59½ will be subject to a 10% penalty.
Once you reach age 73, if you haven’t started taking money out, the IRS will require you to begin taking Required Minimum Distributions.
SIMPLE IRA
This kind of IRA is another type of Non-Qualified employer-sponsored plan and is funded with cash contributions from the employer and employee. SIMPLE IRAs are uncommon but some plans still exist.
As with the other IRA types, most distributions taken before you attain age 59½ will be subject to a 10% penalty. There are a handful of other strings attached. If you have questions about accessing money in a SIMPLE IRA it is best to consult with your CDFA® Professional or Financial Advisor.
Once you reach age 73, if you haven’t started taking money out, the IRS will require you to begin taking Required Minimum Distributions.
You can access funds from each type of IRA without a 10% penalty if you enter into a Rule 72(t) Agreement or qualify for one of a handful of exceptions. A qualified Certified Divorce Financial Analyst™ can help you figure out your options.
Lean More about IRAs
Annuities
Annuity contracts aren’t officially a retirement account, but I’ll address them here briefly because they are often treated and used as one.
What is it?
An annuity is a contract between the contract owner(s) and an insurance company. These contracts come in various structures, and addressing each is well beyond the scope of this article.
The key elements of an annuity contract to remember when dividing an estate are the owner (the person or persons listed as owner) and the annuitant (the person on whose life any living or death benefits are based).
For example, a couple may own a contract jointly – both are listed as owners – but the annuitant is the husband; all benefits associated with the contract are based on the husband’s life.
What you need to know
Like a 401(k) or pension plan, an annuity is divided using a QDRO. Because division or re-assignment of annuity contracts is relatively uncommon, it’s wise to use a QDRO specialist to draft a QDRO used to divide or transfer and annuity contract.
When dividing or re-assigning an annuity, keep in mind that, in general, you can change the annuity owner, but you likely can’t change the annuitant.
As with our example above, the jointly owned contract could be changed to an individually owned contract, but any living benefits or future death benefits would still be based on the life of the original annuitant.
The insurance company that issued the contract may have rules that govern the transferability of that contract. Check with the annuity issuer before agreeing to change ownership on an annuity contract.
Lastly, an annuity contract with an owner and annuitant who are different people is a “complex annuity” with many problems you likely don’t want to deal with. The annuitant should be the same as the owner to avoid issues with benefit payments and taxes.
Once the contract owner chooses to take money from the contract, those distributions are partly subject to income tax. A detailed discussion of annuity exclusion ratio is beyond the scope of this article.
Distributions taken before the contract owner attains age 59½ are subject to a 10% tax penalty.
If you’ve made it through this article, congratulations!
By now, your head may be spinning with all the rules, regulations, and strings attached to retirement accounts and benefits.
Having a competent CDFA® who is skilled in explaining complex rules may be just what you need.
Schedule your free one-hour consultation
[1] Some Qualified Plans require a worker to be employed with the plan sponsor for some period of time (usually three to five years) before they get 100% ownership of the employer contributions. Not all plans use vesting so look for Account Balance and Vested Balance. If both of these numbers are shown, and are different, use the Vested Balance as the value of the plan.
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