How to Split Retirement Accounts in a Divorce

Going through a divorce isn’t easy. In addition to emotional challenges you’ll need to overcome, you and your spouse will often need to consider many financial decisions as well. One such example is determining how to split retirement plans as one of the biggest (and perhaps most complicated) financial decisions you’ll ever make.

Therefore, regardless of whether you’re receiving or giving up money in these accounts as part of your settlement, you need to understand rules and tax implications around them before finalizing your divorce. Doing so can potentially save you money—and headaches!

Community property versus equitable distribution   

If you do not have a prenuptial agreement, arm yourself with knowledge of your family’s financial situation and any applicable laws in the state where you file for divorce: because where you live can determine how your retirement assets are split.

For example, nine states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) have set out to ease the often-grueling experience of splitting assets between spouses by designating those gained during marriage as “community property” (thus owned equally by both spouses). As a result, assets that fall into this category are split evenly during a divorce. Examples of community property include real estate, personal property, savings and retirement accounts, as well as any debts acquired during the marriage.

Typically, any individual assets acquired before the marriage or inherited by one spouse (before or during the union) are not considered community property. However, in some jurisdictions, these assets are commuted to community property. One of the most common ways for separate property to morph into community property is via comingling: such as when one spouse places an inheritance into a joint bank account.

Alaska, South Dakota, and Tennessee have an “opt-in” community property law stating that if agreed to by both parties, assets are split evenly.

Every other state follows “equitable distribution,” meaning that a judge will attempt to distribute assets as fairly as possible during divorce proceedings. Under these circumstances, no set rules determine which spouse receives what (or how much).

If you own homes in more than one state, the location of your permanent legal residence determines whether you are subject to community property law.

Retirement plans and divorce

If retirement assets comprise a significant portion of your divorce settlement, you’ll need to understand the rules of these accounts as well as their potential tax implications.

For starters, you need to categorize each of your retirement accounts before reporting them to the courts. Doing so will help you avoid potential tax and penalty complications. These categories are actually court orders establishing that one spouse has a claim to a portion of the other’s retirement plan account. The type of retirement account determines the category. For example, qualified accounts such as 401k(s), pensions, and 403(b)s fall under the “qualified domestic relations orders” (QDROs, pronounced “quad rows”) category. Meanwhile, IRA accounts fall under the “transfer incident to divorce” category.

Assuming an IRA account is properly categorized, no taxes are assessed on the separation transaction. On the flip side, IRA owners are required to pay an early withdrawal penalty and taxes on the amount transferred.

Once the funds are transferred, your ex-spouse assumes total responsibility for his or her amount. Upon receiving these funds, he or she will therefore need to transfer or deposit that money directly into an IRA within 60 days to avoid paying taxes.

A QDRO works similarly, meaning it’s a tax-free transaction—provided the account is categorized and reported as such. The transfer recipient has a few options including placing QDRO assets into his or her own qualified plan tax-free or rolling over funds into a Roth IRA: in which case the amount is taxed as a conversion but not penalized.

Next, keep in mind the timing of payouts within any retirement accounts you’re splitting: because with defined contribution plans such as 401(k)s, your payment timing depends on the plan and related guidelines. For example, some plans only make an immediate lump sum payout while others employ periodic payments or future lump sum payments. With respect to pensions, as a general rule, you are only entitled to pension payouts when your spouse reaches retirement age. Therefore, knowing the timing of when payments are received is critical: especially when trying to devise a budget and cash flow needs for life beyond the divorce.

Knowing how retirement accounts are taxed is also a critical component of any divorce settlement. For example, just because traditional IRA and Roth IRA accounts each have the same dollar value doesn’t mean they are split down the middle between spouses: as tax was already paid on Roth IRA contributions, meaning that once eligible, account owners can take tax-free distributions. Since traditional IRAs are funded with pre-tax dollars, account owners must pay taxes on these funds once they begin taking distributions.

Annuities and divorce

While we won’t get into too many details here, know that splitting an annuity isn’t so simple during divorce proceedings as these retirement products are often very complex and require detailed calculations. You must also consider potential fees and tax implications when splitting an annuity.

That said, two of the most common methods used to divide annuities are: 1) Processing a withdrawal request from the existing annuity to issue two new contracts (or one contract if the annuity is given to one spouse) and 2) Surrendering a portion (or all) of your annuity and distributing the proceeds.

The method used, type of annuity, and divorce decree specifications (e.g., a stipulation that the withdrawal remain untaxable) will determine tax implications, fees, and benefits. Therefore, speaking with a financial advisor or tax specialist with experience in insurance products and annuities is a smart move: especially if an annuity represents a significant portion of divorce assets.

In sum: retirement accounts and divorce

While splitting retirement assets is sometimes very complicated, remember it’s only one piece of divorce settlement proceedings. Other financial considerations can include home ownership, Social Security spousal benefits, capital gains taxes, and much more. This is precisely why we recommend speaking with a financial advisor who can guide you through the divorce process and help you make sound decisions.

Disclosures: 
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.