Divorce and Retirement Accounts

About 50% of all marriages in the U.S. end in divorce. Beyond the emotional pain, dividing financial assets can be one of the most challenging aspects of the process. What was once a couple’s joint nest egg can now become separate assets of each spouse. While savings accounts and homes are often the main items people consider when dividing financial assets, retirement accounts are just as essential. In fact, they’re typically the largest assets an individual has, aside from their primary residence.

During divorce proceedings, spouses may receive a portion, or the entirety, of funds from the other party’s 401(k) or IRA. However, there are critical processes to follow during these proceedings. Specific legal procedures dictate how to properly divide these accounts to avoid tax and penalties, as well as rules that plan administrators must follow. Being familiar with these rules will help avoid a financial headache.

Former spouses may be awarded funds from an individual’s 401(k) through orders of a divorce proceeding. To avoid taxes and or penalty on the “splitting” of these assets, an important legal document must be in place known as a Qualified Domestic Relations Order (QDRO). An individual, by means of a QDRO, can transfer his or her 401(k) assets to his or her former spouse without being subject to income taxes and/or penalties. 

A court must first issue a Domestic Relations Order (DRO) to an ex-spouse’s 401(k) plan administrator, directing them to pay the funds noted in the divorce settlement to the recipient. Once the plan administrator receives the DRO, they will determine whether it is qualified, and if so, it becomes a QDRO

Once the plan administrator approves the DRO (making it a QDRO), the former spouse typically is given the option to roll over plan assets into an IRA tax free or take a cash distribution subject to income tax. Importantly, distributions from a 401(k) pursuant to a QDRO are exempt from the 10% early distribution penalty, thus allowing a former spouse younger than age 59½ to receive penalty-free distributions. However, the distribution remains subject to income tax.

A distribution by reason of QDRO cannot force or override 401(k) plan rules to offer the former spouse a distribution option that is not already offered by the plan.  Therefore, we suggest checking with the plan administrator or accessing the Summary Plan Description to determine QDRO distribution timing. In other words, timing of the distribution pursuant to a QDRO is dependent on plan-specific rules. For example, an ex-spouse might have to wait for his or her former partner to sever service with the plan or retire before being able to receive funds.

One option when receiving funds due to a QDRO is for the former spouse to initiate (again dependent on plan timing) an IRA rollover. Rolling funds into an IRA is tax free, making it an appealing option.  Now, the funds are in an IRA owned by the former spouse.  In other words, the former spouse is now the IRA account owner and subject the IRA rules.

Should the former spouse need income, there’s a tax advantage to taking a distribution directly from the 401(k) plan and not facilitating an IRA rollover. QDROs are exempt from the otherwise 10% early distribution penalty tax that generally applies to distributions for 401(k) plan participants that are under age 59 ½.  Therefore, where the former spouse has not reached age 59 ½, there is an exception to the 10% early distribution penalty from only the 401(k) plan. The funds, however, will still be subject to income tax (federal and state if applicable.) Notably, if the funds are first rolled into an IRA followed by a distribution, the 10% penalty tax does apply. The QDRO exception to the 10% penalty tax does not apply to IRA distributions. 

Legally, IRAs cannot be transferred, gifted, or assigned to a new owner during the lifetime of the original account holder; an exception applies in the case of divorce. IRA funds can be transferred tax free from spouse to former spouse only where allowed under a court-approved divorce decree or legal separation agreement. In this case, the court must provide a divorce decree or separation agreement that states the IRA owner is no longer married. Without this documentation, there is no legal authority for the IRA to be split or divided.  QDROs do not apply to IRAs.

Either the divorce decree or a separation agreement that is incorporated as part of the divorce settlement will spell out who gets what amount of the IRA.

Once the divorce is granted by the court, the agreement or divorce decree is delivered to the custodian to “split” the IRA in a tax-free direct transfer per the terms of the agreement.  This is the only method to properly split an IRA tax-free in the case of divorce.  Moving IRA funds through any other method would instead be a distribution subjecting the IRA owner to income tax and potential penalties. 

 

·   When dividing 401(k) and IRA assets during a divorce, each account type has its own set of unique transfer rules and procedures to avoid tax and penalties.

·   401(k)s require a QRDO, are subject to plan administrator approval, and have various options for the distribution of funds. Distributions are exempt from the 10% early distribution penalty tax typically associated with 401(k)s for those participants under age 59 ½.

·   The division and distribution of IRAs requires a divorce decree and can only happen via direct transfer from the ex-spouse’s IRA account. Any other method will subject the IRA account owner to income tax and potential penalty 

For more guidance on the division of retirement assets in the event of divorce, speak with a financial or tax professional to ensure you avoid possible taxes and penalties.