After 10 years of marriage, you and your spouse decide to divorce. You amicably agree on a 50/50 split of all assets. But wait. Through your employer, you have a pension. Likewise, your spouse has a 401(k). You both have IRAs. How do you legally divide these retirement assets? More importantly, how do you divide them without incurring tax penalties? To avoid the mistakes in that befall many couples as they divide their retirement assets, it pays to familiarize yourself with the basic IRS rules that govern these matters.
Pensions and other Employer-Sponsored Plans
The law says that your spouse is entitled to a portion your pension’s account balance, even though the pension is offered by your employer, and you have contributed to the plan through deductions made from your paycheck. As part of the divorce settlement, the spouse requesting part of a pension would hire an attorney to create a Qualified Domestic Relations Order (QDRO), a decree that spells out an individual’s right to participate in a given retirement plan. The requesting spouse would then submit the QDRO to the administrator overseeing the requirement plan in question. Upon accepting the QDRO, the administrator would divide the pension assets (typically the balance at the time of divorce) between the two divorcing spouses. For tax purposes, the requesting spouse is considered a full plan participant and would be subject to all applicable taxes when the money is received in retirement.
As with employer-sponsored pension plans, divorcing spouses typically create a QDRO to divide assets held in 401(k) accounts. The plan administrator at the company or organization sponsoring the 401(k) benefit will divide assets according to the terms spelled out in the QDRO. In most cases, those terms call for a 50/50 split of moneys accrued at the time of divorce. Yet, because 401(k) assets can be sizeable, some couples actually negotiate different terms, trading equity in jointly held assets for equity in the 401(k). However the account is divided, the spouse taking the distribution can avoid penalties and taxation by including in the QDRP instructions for the plan administrator to set up a new 401(k) account in the receiving spouse’s name. The other option is to roll the distribution into an IRA. Either way, tax deferral can be maintained and no penalties will be paid.
By mutual agreement, you can decide to keep your own IRAs, but the law says that each spouse is entitled to half of the other's retirement assets. So unless you both have the same amounts in your respective IRAs, get ready to split up the money in these accounts. If you receive a distribution from your spouse’s IRA, you can roll it over into your IRA tax free. You cannot, however, just take the money and stick your spouse with the withdrawal penalties and tax liabilities. From the moment you take possession of money from an IRA, you are responsible for it. Roll it into your own IRA and move on.
Choose Your Beneficiaries
One last step that many divorcing spouses overlook is the selection of new beneficiaries on their retirement accounts. More than a few divorcees have gone through the considerable expense of dividing assets and paying lawyers, only to die suddenly and have a former spouse take possession of their assets anyway. Such situations can lead to lawsuits (and more legal expense) involving new spouses, children, family members and friends who feel they, and not a former spouse, should inherit the assets of the deceased. Before you sign any final divorce settlement, designate new beneficiaries.
In a perfect world, couples could rationally dissolve their marriages and divide their assets without tears and anger. We don’t live in a perfect world. Because retirement assets are so often among a couple’s most valuable property, divorces can quickly become blood feuds in which spouses try desperately to keep each other from sharing in jointly held IRAs, 401(k)s and pensions. The law anticipates this. Almost all state divorce law views retirement assets as being jointly held. Furthermore, most employee benefit plans require a spouse’s signature before major changes — like a husband making a big withdrawal from his 401(k) just prior to the start of divorce proceedings — can be made. If you anticipate an acrimonious divorce, seek counsel from an experienced divorce attorney as soon as possible to better acquaint yourself with the divorce laws of the state in which you live.