Divorce is a difficult experience for most people for many reasons; finances are at the top of that list. Splitting up often involves separating housing, which increases costs for both parties. Then it comes time to divide the assets, including retirement accounts. The amount you get in a divorce settlement depends on a variety of factors, including how long you were married, where you live, and whether both spouses have the resources to support themselves.
Retirement accounts are special because they have unique tax advantages and other features that require individual consideration as part of the divorce settlement. Knowing what to expect can help you avoid unpleasant surprises.
What It Means to Split a Retirement Account in a Divorce
How are retirement accounts divided in divorce? These accounts are complicated. They tend to be one of the biggest marital assets, along with your home. Unlike real property, which you can sell and divide the proceeds, you can’t just withdraw money from a retirement account and split it into two piles. You must file specific orders to divide the account according to the divorce settlement.
If you’re contemplating divorce, you are probably already preparing for a major financial life event: Divorce tends to be expensive. Division of your assets depends largely on the state you live in. Some states divide assets acquired during the marriage 50/50, while others may negotiate the split based on income and length of the marriage. In most cases, retirement accounts with contributions made during the marriage are subject to division.
The amount you can take for yourself also depends on the types of assets and when you acquired them. You’ll need to show proof of property or retirement savings you accumulated before the marriage, especially if you plan to claim it as separate property.
In short, this is not a process you want to skim or let emotions dictate. Poor planning in this step can permanently affect your retirement security.
Types of Retirement Accounts That May Be Divided
Dividing retirement accounts in divorce can be tricky because of the way that those accounts are structured and managed. Since many retirement accounts are tax-advantaged, like a 401(k) or traditional IRA, you can’t just withdraw a lump sum without following the guidelines for distributions or considering the tax implications of retirement accounts.
The way that you approach splitting the account depends on the type. Dividing an IRA could be simplest, as you may be able to directly roll over funds from one IRA to another. If the account in question is a defined contribution plan, like a 401(k) or 403(b), you may need a Qualified Domestic Relations Order (QDRO) to disburse funds to one spouse.
If you or your spouse has a defined benefit plan like a pension, the complication may increase. Dividing a pension depends on state law and the rules governing the pension itself.
Your strategy and tax implications also depend on whether the account is a pre-tax or after-tax asset. Roth IRAs may be the easiest to split because, as an after-tax asset, you can withdraw contributions tax-free at any time in most cases.
How a QDRO Works (and When You Need One)
For qualified employer plans, like your 401(k) or 403(b), you can’t just rely on the divorce settlement. You will also need a Qualified Domestic Relations Order, or a QDRO. This is a legal order separate from the divorce decree and does not apply to IRAs.
Forming a strategy for the QDRO, and making sure everything is correct on the order, can help you avoid an unexpected tax burden or a rejection of the order. A QDRO will usually assign a portion of the account to the former spouse, but it may be assigned to a child or other dependent.
The way that the account’s funds are distributed affects taxation and possible penalties. If you take the portion of the account assigned to you and roll it over to your own retirement account, you may not have to pay taxes on it. You might be able to take a direct disbursement to pay for immediate expenses, but you’ll face a 20% withholding for taxes and tax liability on that disbursement.
Keep in mind that the QDRO is closely tied to the divorce settlement. If the percentage of the division or other information doesn’t match, the plan sponsor may not be able to make the disbursement. Be sure to coordinate with your financial advisor and attorney before you make any final decisions.
Tax Consequences of Splitting Retirement Accounts
While dividing retirement accounts can be frustrating in itself, you also have to consider the tax implications. If you roll over a retirement account disbursement straight into another retirement account, it may be identical to any other rollover – no sudden tax bill to pay. That’s true whether you use a QDRO to split a 401(k) or the divorce settlement to divide an IRA.
If you don’t roll over the funds, things get more complicated. Early withdrawals from traditional IRAs and 401(k)s, which applies for disbursements made before age 59.5, often trigger a 10% penalty on your income taxes. You may be able to claim an exemption on that penalty if the split happens as a result of a QDRO, or for other reasons. These withdrawals are also usually taxed as ordinary income.
It’s important to understand that even if your divorce settlement requires an equal-value split, it may not be equal after taxes. Seeking to protect your after-tax retirement income is all about understanding how disbursements affect your individual tax liability, whether you are retired or still employed at the time of the divorce.
How Divorce Can Impact Your Long-Term Retirement Plan
Divorce creates a number of long-term financial impacts, especially for retirement. You likely have fewer assets and higher expenses. It often requires a revision to your retirement timeline and plan.
In the leadup to divorce, start evaluating your risk management strategy. Taking a big disbursement or a cut to your retirement assets during a market downturn can affect your fund’s performance for the long-term. As you get closer to retirement, you’ll probably shift to a more conservative investment model to preserve your wealth.
Now’s the time to take a breath and consult your financial advisor. Emotional decision-making can trigger you to make snap decisions that lower your anticipated retirement income or push back your retirement date.
Common Mistakes to Avoid When Dividing Retirement Accounts
Since splitting up retirement accounts is part of the larger divorce settlement, you need a strategy for it. Remember that you have some power to negotiate how assets are split, even if you can’t change the exact percentage of the division. A well-reasoned plan can minimize your chances of making these common mistakes:
- Focusing on what you get, instead of the after-tax value
- Taking early disbursements if you don’t need it
- Forgetting to update beneficiaries after the settlement
- Failing to coordinate your plan between your attorney and financial advisor
- Letting anger or fear guide your decisions
Maintaining discipline during the process can help you avoid making costly missteps that further disrupt your retirement goals.
When to Involve a Financial Advisor During a Divorce
Ideally, you will involve a financial advisor in your retirement planning long before you ever consider a divorce. If you haven’t, divorce is a great time to start. Your legal team may be able to share information about the financial implications of a particular strategy, but it’s not the same as working with a financial advisor.
Hiring a financial advisor is a critical part of comprehensive wealth management. It’s a decision that helps you fit everything into the big picture – your post-divorce assets, your income, your retirement fund, your long-term plans, and more. Financial advisors can help you:
- Outline a post-divorce planning roadmap
- Model various scenarios to help you refine your retirement plan
- Collaborate with your divorce team
- Coordinate with tax planning
Financial advisors have a fiduciary responsibility, which requires them to make decisions in your best interest. They also strive to provide crucial guidance at a stressful and emotional time.
Planning the Next Chapter After a Divorce
Once the divorce is settled and your retirement accounts are divided, it’s time to take a moment to plan ahead. Even if you’re struggling to manage your finances in the moment, you still have the ability to build a financial plan that provides guidance for the future.
Your next steps are clear, whether you feel like you’re on shifting sands or stable ground. Retirement planning services can help you:
- Redefine what financial independence looks like for your new situation
- Update your retirement projection
- Create a sustainable income strategy
At Brown and Company, we provide qualified financial planning that puts your best interests front and center. Contact us to see how we can help you manage your retirement funds during divorce or other life events.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Investing involves risk including loss of principal.
No strategy assures success or protects against loss.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.