What Happens to My Retirement Accounts After Divorce?

Whether before or during your divorce proceedings, it is important to investigate the types of accounts that you and your ex-spouse have in common. It is a mistake to assume that a 50/50 split of retirement assets is always equitable. Because of the different tax implications, investment selections, and payout structure of retirement accounts, not every dollar should be treated equally.

1. Traditional IRA/Roth IRA – A key concern when thinking of how/when to split IRAs in a divorce is tax treatment. Dollars/investments in a Traditional IRA are considered tax-deferred. This means that the account growth is not taxed until the owner begins to spend money inside of retirement. A Roth IRA is different in that the money grows tax-free and when used correctly, is tax-free after retirement/age 59.5.Because of the tax treatment, when $100,000 comes out of a Traditional IRA, the ‘take-home’ amount could be 20-30% less after paying income tax rates. The same amount of money inside of a Roth account, assuming withdrawal requirements are met, would be a higher amount in your pocket.

   The IRS has allowed for some exceptions to pre-59.5 age withdrawals in the case of divorce: “The only divorce-related exception for IRAs is if you transfer your interest in the IRA to a spouse or former spouse, and the transfer is under a divorce or separation instrument”. In other words, if in the divorce, you are granted a portion of your spouses’ IRA accounts, you are able to withdraw money without paying the 10% penalty. It is very important to note that the withdrawal amount from a Traditional IRA will still be subject to your income tax rates. Read the full list of exceptions/details on the IRS site here.

   If you or someone you care about finds themselves trying to understand or make the best decisions in the financial maze of divorce, reach out first to an attorney, and then to a financial planner to guide you through.

2. 401(k) / 403(b) – These employer-sponsored plans allow employees to save for retirement with pre-tax dollars. Contributions often come with employer matching, enhancing the growth potential of the account. A 403(b) is similar to the 401(k) but specifically for employees of nonprofit organizations and certain government entities.Importantly, a Qualified Domestic Relations Order (QDRO) is usually required to divide these accounts without incurring tax penalties. A QDRO is a legal order necessary for dividing employer-based retirement plans like 401(k)s and pensions. It outlines how the plan should be split and allows for a tax-free transfer. Failure to implement a QDRO can result in tax penalties. The timing and execution of a QDRO is crucial to ensure the alternate-payee (spouse receiving funds) receives the correct amount in a timely manner. The QDRO should be finalized and approved by the court before retirement benefits are distributed. After the divorce is finalized, the QDRO must be submitted to the retirement plan for implementation.

   Investopedia explains the different options of payout from a QDRO agreement:

   “Alternate payees may have several choices for how they receive their money, depending on how the QDRO is written. For example, the QDRO may provide for either a “shared payments” or “separate interest” arrangement. With shared payments, the spouse and ex-spouse will split, proportionately, each benefit payment that the plan participant receives. With a separate interest arrangement, the 401(k) account will be split into two parts, again proportionately, and the alternate payee’s share may be put into a separate QDRO account by the plan’s administrator. In a separate interest arrangement, the alternate payee can choose to receive benefits on their own timetable. They may also have the option to take their share as a lump sum and roll it over into their own 401(k) plan or an IRA in their name.”

3. Pension Plans – Uniquely, pension plans can be an extremely emotional asset to consider splitting in a divorce. This may be due to the fact that pensions are oftentimes associated with especially challenging careers like police, fire, or education. These defined-benefit plans are usually based on a formula that considers factors like salary history, years of service, and a predetermined multiplier. For example, a common formula might provide a benefit equal to a percentage of the employee’s average salary over their final years of work multiplied by their years of service.Because of the unique challenges of valuing a pension plan, it is crucial to receive an actuarial analysis to determine various outcomes of splitting this account. Your pension, like any other asset, is part of a larger conversation of asset and debt distribution in your divorce. In mediation, clients make informed decisions and may trade-off one asset for another. Check out this article for other commonly asked questions when it comes to splitting pension plans during divorce. At the onset or in negotiations of your divorce, consider hiring a financial professional with qualifications such as CFP™ (Certified Financial Planner™) or CDFA® (Certified Divorce Financial Analyst) to help you navigate your options.

Every bit of effort in understanding the division of financial assets in divorce must be tied to a plan. Moving through divorce entails more than just opening accounts, changing beneficiaries, or considering tax consequences: there will always be a phase of rebuilding. Having healthy expectations and a clear financial strategy will create peace of mind in what can be some of the hardest months, or years, of a persons’ life.